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When Life Gives You Lemons: Consider a Roth Conversion

When Life Gives You Lemons: Consider a Roth Conversion

Yes, I know how corny that sounds and I know that a Roth conversion won’t quench your thirst during these hot summer days, but it just may help you create something even sweeter- a family legacy of tax-free income. We believe some of the best opportunities for long term success are solidified in the financial lemons thrown our way. Here is a real story of a Sacramento family turning serious lemons that were thrown at them into a legacy for their children. For privacy reasons the client’s names and details have been altered.

The Smith family are Sacramento natives who run a successful construction business. They have been family owned for two generations and the two sons, Peter and Ken were responsible for running and growing the business. The Smith Brothers spent their careers building local homes with Smith Construction since college. Both Peter and Ken were involved in the community and loved the Sacramento rivers for boating, fishing and jet skiing. The older brother Peter & his wife Patty just sent their last child off to college and were excitedly beginning to day-dream about retirement. Ken and his wife Katie were getting ready to send their eldest daughter to college.

Enter Lemons.

In 2009, the Great Recession caused home building to slow significantly in Sacramento. Even during the downturn, Peter and Ken were adamant about not laying off their workers even if it meant the business was running a deficit. On top of that, the brothers were faced with a worst-case scenario: Smith Construction was named in a multimillion-dollar class action lawsuit in which one of their subcontractors was accused and found guilty of negligence. In our overly litigious society, any small business owner will tell you that litigation is one of the biggest potential threats to their business. For Peter & Ken this a nightmare situation: their business had slowed significantly, and the lawsuit settlement was going to be a major loss for the business. For Peter, this also meant delaying he and Patty’s retirement from Smith Construction while for Ken, it meant major uncertainty about how he and Katie would pay for their daughter’s upcoming college tuition.

So, what can be done?

After the initial shock of the situation wore off, Peter and Ken enlisted Genovese Burford and Brothers to help them personally navigate this financial conundrum. The Smith Brothers tried to remain calm and refocus their energy on achieving their goals, despite the serious threat to their financial lives. GBB advisors worked with Peter, Ken and the CPAs to see how they each could utilize the devastating business loss. For Peter, the immediate goal was to make sure he and Patty were still able to retire even if delayed. For Ken it was making sure that assets were made available for their daughters’ college.

One recommendation was to take each of the Smith Brother’s pre-tax retirement plans and convert them to Roth IRAs. Smith Construction was structured as a S Corp which meant that gains or losses in the business flow through to each owner individually. Due to their low tax rate, Peter and his wife Patty, who also worked for Smith Construction, were able to convert a few million dollars’ worth of pre-tax money into after-tax Roth IRA money (without paying any taxes). The IRS allows tax payers to use losses to offset income and in this case the income received through the Roth Conversion was offset by the substantial business loss. This action took a very sour loss and created a pitcher of very sweet money for Peter & Patty that would grow tax-free and never have a Required Minimum Distribution. Ken also utilized this strategy to convert his retirement plan to Roth IRA.

Why is Roth money so sweet?

As people enter retirement, it becomes more and more important to have different sources of income to fund their goals. Many people save through an employer sponsored plan (like a 401(k) or 403(b)). Saving this way creates pre-tax assets that must be withdrawn starting at age 70 ½ and taxed at the highest marginal tax bracket. Roth funds are assets that have already been taxed and are able to grow income tax free for life and are not required to be withdrawn starting at age 70½. By completing a Roth Conversion during a period of low or no income, clients are creating an efficient vehicle for growth and potentially leaving their heirs with a source of tax-free income for the rest of their lives.

Does our story have a happy ending?

Smith Construction recovered from the downturn and began to thrive again just a year or two later. The lawsuit was settled rather uneventfully, and life went back to normal for the Smith Brothers. In the case of Peter & Patty Smith, their converted Roth IRA assets grew substantially over the years.  Unfortunately, Peter and Patty passed away few years ago, leaving their adult children a substantial amount of money on which of course, they do not pay taxes on. By thinking strategically during this tough period for their business, Peter and Patty helped to improve the estate that they left to their kids.

Since Ken was younger than Peter, his Roth money continued to grow as he helped the business recover and eventually to thrive. He and Katie look forward to using the Roth IRA as a tax-free source of income during retirement allowing them to have greater flexibility with their financial futures.  

When a family business goes through a financial loss (due to market downturn or unforeseen circumstances), it can often take years to recover. This story is an example of clients who faced a very sour situation, kept their cool and utilized their advisors to help create opportunity out of a tough situation. At GBB, we believe people are best served when they have a team of advisors who can provide insight and perspective during times of financial or market uncertainty. Our job as advisors is to help you think creatively and make the best possible lemonade regardless of lemons that life has thrown their way. 

Give us a call at (916) 924-7527 or complete our contact form to speak with an advisor today.

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