Fixing IRA Transactions with Alternative Assets

Do some of your clients hold alternative investments inside their IRAs?  Have they taken RMDs, completed Roth conversions or other taxable events?  If the answer is yes, then it is very likely that they have a problem.  Alternative assets commonly held in IRAs include non-traded REITs, hedge funds, non-traded BDCs, private investment funds and other illiquid investments.  Such assets can be difficult to value which directly impacts the tax consequences of IRA transactions.  All IRA assets must be reported at their fair market value (FMV) for reporting purposes which for most investments means their trading price.  Alternative assets typically do not trade on established exchanges, and thus can cause adverse consequences for IRA owners when reporting taxable events.

For example, take the case of hypothetical client Mr. Stone who is 71 and has a traditional IRA with a purported $500,000 portfolio of non-traded alternative assets.  This is the value used to calculate Mr. Stone’s taxable 2012 RMD of roughly $18,900.  We take it for granted that this is the correct RMD and the calculation was based on the proper asset valuation.  But what if the illiquid alternative asset was still being valued at Mr. Stone’s original purchase cost from five years earlier with no subsequent update since the asset does not have a readily ascertainable trading price?  It is highly unlikely that the fair market value (FMV) is still $500,000.  If it is worth more, then Mr. Stone could face penalties for not taking the proper amount of RMD.  If it is worth less, Mr. Stone took more money from the tax protected environment of his IRA and incurred more tax than necessary.

A similar scenario occurs where clients completed Roth conversions of IRAs holding alternative assets.  If the investments were overvalued, the client reported excess taxable income and paid more tax than required.  If the investments were undervalued, the client could face unpleasant penalties, interest and additional tax.

Alternative assets are generally subject to valuation discounts for factors such as lack of marketability, illiquidity, lack of control, etc.  So luckily, in the majority of cases we find alternative investments to be overvalued for IRA reporting because these applicable adjustments have not been taken into account.  This means clients often stand to benefit by correcting the errors and requesting a refund of the excess tax paid or reduction of RMD penalties and so on.

The process to correct these issues can be detailed and complex requiring specific actions in a specific order in many cases.   Jagen™ offers direct consulting on these types of cases and can work with you and your clients to complete this process and improve IRA results.  Contact our office to discuss particular client cases.

Author: Joe Luby, CFP®

©2012 All Rights Reserved.

Benjamin Franklin Promoted Tax Alpha

Clients want more money.  They want growth or income or preferably both, thankyouverymuch.  In every case, they give their advisor a fistful of dollars and expect two fistfuls in return (hat tip to Clint Eastwood).  Rare is the client that asks only for the same number of dollars to be available several years after hiring an advisor.

Advisors typically design a portfolio of assets intended to produce more dollars at some point in the future than the client started with.  The ability to successfully generate excess return over a stated benchmark produces investment alpha.  A positive alpha of 3.0, for example, represents a return three percentage points higher than the benchmark over a specific timeframe.  This is quite a challenge even for the best advisors.  It requires them to be right…a lot.

However, there is a different type of alpha that can be planned for, calculated in advance and achieved consistently.  Such is the nature of tax alpha.  Tax alpha is created when a particular planning strategy results in a reduction of taxes owed.  It provides the same net result as investment alpha, namely, more money in the client’s pocket.

Did you know Benjamin Franklin was the first known proponent of tax alpha?  His quote “a penny saved is twopence dear,” later updated into modern English as “a penny saved is a penny earned,” is directly on point.  A penny saved in tax is just as good as a penny earned from investment performance.  One might contend that Mr. Franklin was speaking against frivolous consumer spending, but I suspect he would equally advise against overspending on taxes as well.

A good advisor will sharpen up on advanced tax planning strategies as much as they will on the latest investment information.  This is especially pertinent in 2012 to help clients limit the cost of pending tax increases slated for January 1, 2013.  Increased tax costs are akin to investment losses in a portfolio while tax savings are akin to investment gains.

One example of how to add tax alpha for clients contemplating wealth transfer strategies can be found in our report titled “Waiter, There’s a REIT in my GRAT!” posted in the Education & Resources section of this site.  And pick up a copy of our book, KEEP IT! Advanced Tax Strategies for IRAs, for many ideas on how to provide significant tax alpha to retirement accounts.  Stay tuned for many more updates and ideas from Jagen™ throughout the rest of the year.

Tax mitigation strategies can provide “guaranteed” returns that are only dependent on following the rules.  Geopolitical activities, investor emotions, market movements and corporate profits have no bearing on returns generated from tax alpha strategies.  Wise is the advisor that can generate investment results via tax savings even if a portfolio is flat.  Ben would be proud.

Waiter, There’s a REIT in my GRAT!

The next line in the old joke about a fly in the soup has the offended patron asking the waiter: “what is he doing in there?!”  To which the clever waiter replies: “it looks like the backstroke, sir.”  Please excuse my bad take off on the joke, however, some estate planners might react similarly upon the suggestion of a REIT in a GRAT.  That is, until they discover how much “flavor” this combination really has.

Non-traded REITs are popular and widely held alternative investments with billions of dollars flowing into them annually.  It’s an oxymoron to call a widely held asset “alternative,” but so it goes in the industry.  They are typically sold on the basis of portfolio diversification into commercial real estate and relatively high yields in the form of dividends.  It’s not uncommon to find non-traded REITs yielding between 5% – 7% even in the early stages.  But what do they have to do with GRATs?

Prohibited Transactions Do Not Disqualify an IRA…Always

The title of this piece probably goes against everything you’ve ever been told or read about prohibited transactions and IRAs.  That’s because (almost) everything you’ve ever been told or read about these transactions is incorrect.  Calm down, control your breathing, it’s going to be OK.  We’ll get through this together.  I used to believe that all prohibited transactions disqualified an IRA also because that’s what I had always heard or read.  That was before a very knowledgeable ERISA attorney corrected me and caused me to review the rules again in an attempt to prove him wrong.  Instead, the rules proved him right.

Who Cares About the AI Market? You Should.

Dear Friends & Colleagues,

I had an interesting conversation this week.  The founder of an RIA firm in the Midwest contacted me to discuss the concepts outlined in our latest white paper.  The paper is titled “Acres of Diamonds – How to Double the Size of the Alternative Investment Market” and can be downloaded for free here.  Even more interesting is the fact that this firm does not currently use many alternative investments (AI) in their client portfolios.  Why did they read a report about increasing the AI market?

The title may not be catching for attorneys, CPAs and financial advisors thinking “who cares about the size of the alternative investment market.”  However, once you understand the concepts presented, you will scramble to help increase the size of the AI market.  Many will demand more AIs for their clients specifically for the planning opportunities presented.

The call from the RIA firm this week proves my point.  They read the white paper and wanted to know which AI companies followed the policies highlighted in the report.  Specifically, they wanted to talk to those AI firms about starting to allocate significant client funds to their products!  The piece definitely struck a chord with this advisory firm once they realized the amazing financial and tax planning opportunities for clients holding AIs.

And that’s the point.  Attorneys, CPAs and financial advisors who understand the financial and tax planning opportunities hidden within the AI market demand more of these assets for their clients.  So take a look at the white paper and see if some of the concepts strike a chord with you and how they may fit into your client scenarios.

Best Regards,

Joe Luby

Founder