If you’ve decided to invest in your new company through its retirement plan, commonly known as doing a “ROBS” transaction, you probably are already aware of the tax advantages, namely that you get to invest tax-deferred dollars in your new company and see those savings grow as your company increases in value. It is the dream on offer to any new ROBS owner–you get to start your company with untaxed capital, work hard to build the company’s value over the years, and eventually sell the company or retire; only later, when you take distributions, will you be taxed on your hard-earned investment.
With some advance planning, you could save yourself even more in total tax payments on your ROBS investment. Imagine selling your company at a profit and not owing any tax on that gain when you withdraw your plan funds in retirement. That could happen if you do an in-plan Roth conversion of your ROBS shares, provided you hold the converted stock in the plan for at least five years.
However, a Roth conversion of a ROBS investment is not to be undertaken lightly, because it involves transaction costs, and it comes with financial risk.
How to Accomplish a Roth Conversion
The conversion may only occur within a plan that’s already invested in the ROBS corporate stock or Qualifying Employer Securities (QES). The logistics of the in-plan conversion are handled by your plan’s third-party administrator, who will help you prepare the necessary documents. It’s also a good idea to check in with your ERISA counsel and tax advisor before undertaking a conversion.
In a nutshell, the steps are as follows:
- Get a professional, third-party appraisal of the company’s fair market value (FMV), in a written report.
- Report and pay income tax on your individual Form 1040 on the taxable amount (FMV) of the converted QES.
- Create a new Roth subaccount for the converted QES.
- Hold the Roth for at least 5 years from January 1 of the year of conversion; after that period lapses, the proceeds of any liquidated Roth QES will not be taxed upon withdrawal from the plan, no matter how much they have appreciated in value.
For example, let’s say the QES are worth $100,000 when converted to Roth in 2023; you must declare $100,000 as 2023 taxable income on your Form 1040 individual income tax return. (Note that for the corporation this in-plan conversion is completely cashless and tax neutral; the conversion is a plan transaction for your benefit as the ROBS participant and has no impact on the corporation.)
The Roth conversion tax bill can be daunting, especially considering that the conversion does not provide any cash to help you pay the tax. For example, if your individual income tax on $100,000 in 2023 were $25,000, you would have to find a ready source of cash to pay that tax bill by April 15, 2024.
Your reward for voluntarily taking this up-front tax hit is that, if you continue to hold the shares for five years after the conversion, you will never have to include in your taxable income any increase in value on those shares. Having paid the tax on the $100,000 in 2023, if you a sale of the corporation in 2030 netted your plan account $1 Million, you would be able to withdraw that $900,000 tax-free in retirement.
The Risk of Loss
As appealing as it is to consider the powerful upside of a Roth conversion, there is a genuine potential downside, which should be carefully considered before doing a conversion. The primary risk is that the corporation does not increase in value, nullifying the tax advantage of a Roth conversion.
What if the Roth conversion occurred at a value of $100,000, but then the company later sold for only $90,000? Tax would have been paid on a higher amount, and earlier, than if the Roth conversion had not occurred.
Another risk is having to distribute the stock before the end of the 5-year minimum holding period, which would incur tax on the earnings in the Roth account. (Note that even after 5 years, you must still be at least 59 ½ to withdraw from a Roth account without incurring the early-withdrawal 10% penalty; death and disability are exceptions to this. Rollovers from a Roth 401(k) account to a qualified plan or IRA would maintain the tax-free status of the Roth account.)
Timing is Key to the Upside of a Conversion
This is the dilemma and the decision for the ROBS owner–when, and whether, to “Rothify.” As a business decision, the challenge is to find the sweet spot; that is, when your company is still at a low enough value for you to afford to pay tax on its value, but already mature enough that you are confident that it will continue to grow in value.
ROBS plans offer business owners a unique combination of opportunities to grow their business and save for retirement, and a Roth conversion is another way of maximizing those tax benefits that is worthy of careful consideration.