Imagine you just made an investment – and it lost value overnight. Most investors feel disappointed when they see red on their performance chart. However, an initial loss in value, seemingly overnight, is expected and even desired when an investment employs the J-Curve technique.
Long known to private equity and real estate investors, the J-Curve can offer significant potential to investors who want to harness short-term losses for long-term and tax-efficient gains.
How Does a J-Curve Work?
Try to chart the following hypothetical return of a venture capital fund. The early years are marked by negative returns due to management fees, start-up costs, and capital deployment before the fund begins to appreciate assets, generate income, and provide a positive return. The cumulative return curve initially slopes down, but over time, as value becomes realized through exits and cash flow, it begins to trend upward, forming a “J” shape.
The J-Curve is a classic risk/reward trade-off. Investors endure an initial negative performance with the expectation of gains later in the fund’s life. Of course, the expectation of gain is just that – an expectation, not a guarantee.
The J-Curve in Roth Conversions
What if the J Curve behavior – that early drop followed by a rebound – powers a unique opportunity for a Roth conversion?
The IRS allows pre-tax money in a Traditional IRA or 401(k) account to convert to Roth dollars. Investors pay the tax at the time of conversion in exchange for tax-free growth and future withdrawals, provided certain conditions are met. Certain private equity and real estate investments offer this J-Curve Roth conversion.
For example, consider a hypothetical investment – a development project of single-family homes across a vacant lot. Ground-up development projects like this are ideal because the investment begins with no existing real assets or income. An investor may put in pre-tax IRA money during the early stages of development. In development real estate especially, early-year losses can significantly reduce the value of the investment, allowing for an opportunity to convert to a Roth at a depressed value and lessen the tax consequences.
Once the fully built single-family development generates income and appreciates in value, the investor’s value grows; however, the money is now all Roth dollars. As the investor takes income or later sells his share of the project, those dollars may come back entirely tax-free.
A word of caution to investors considering a J-Curve Roth conversion: like losing a game of limbo, sometimes you cannot go too low. The IRS closely monitors low-basis Roth conversions, particularly those involving private investments. This may increase your risk of an IRS audit. If the IRS determines the valuation is artificially low during the audit, they could challenge the conversion and impose taxes based on a higher deemed value.
Now, the IRS does not specify a precise threshold for what constitutes “too low” of a valuation in a Roth conversion. The valuation used for the Roth conversion should be reasonable, supportable, and well-documented. The IRS expects independent and thorough third-party valuations in the event of an audit.
Who Should Consider a J-Curve Roth Conversion?
Most people would like to save on taxes. But the J-Curve strategy is ideal for:
- Individuals who expect to be in a high tax bracket in the future or during retirement
- Investors holding undervalued assets in tax-deferred Traditional IRAs with predictable recovery and growth trajectories
- Pre-retirees facing large required minimum distributions (RMDs) in Traditional IRAs and/or 401(k) and 403(b) plans
When used in conjunction with other tax mitigation strategies, such as tax-loss harvesting, charitable giving, or investing in oil and gas partnerships, the J-Curve Roth conversion strategy becomes even more effective. As always, these strategies demand careful execution and coordination with experienced tax and financial professionals. If you’re converting alternative assets, such as private equity or real estate, work with a tax attorney or CPA and a financial advisor who is familiar with IRS guidelines on Roth conversions.
Securities are offered through Arkadios Capital. Member FINRA/SIPC. Advisory services are offered through Creative Capital Wealth Management Group. Creative Capital Wealth Management Group and Arkadios are not affiliated through any ownership. This material was created for educational and informational purposes only and is not intended as tax, legal or investment advice.