Where to Find Money for a ROTH IRA Conversion
Converting a traditional IRA to a ROTH IRA will create an account that can generate a tax free income during retirement or a tax free asset to give to ones heirs. However, making the conversion creates a taxable event which deters people from doing it. Should you make the conversion? Where will you get the money to pay the taxes?
As with any financial planning question, the answer is "it depends" but chances are you should and in my opinion using debt like a loan from home equity line of credit or mortgage refinance is perfectly acceptable and can decrease your overall risk.
The purpose of this Hub is to give a perspective on the possibility using ones home equity in order to buy out the "governments lien" on a traditional IRA.
What is a "government lien" you ask?
When an individual makes tax deferred contributions to a retirement account like a traditional IRA, they aren't saving taxes. Instead, they are borrowing time and will eventually have to pay those taxes back. Therefore, in a way, the individual saving for retirement is getting a loan from the IRS.
The problem with this arrangement is that the traditional retirement account owner doesn't know what the "interest rate" of this loan nor do they know for sure when it will become due. It depends on how much the account grows, what their tax rate will be in the future and when the money will be withdrawn.
Your Opinion on Debt
Do you think that being 100% out of debt is important for financial success/
What is "Debt?"
The dictionary says that the definition of a debt is “something that is owed or due.” When an individual takes a tax deduction from their current income for contributing to a qualified retirement account (IRA, 401k, 403b etc), they are not necessarily saving any additional money for themselves. Instead, what they are doing is delaying the inevitable (paying income taxes) for a future date and time. The whole logic in delaying this taxation is two fold.
First, there will be more money in said account to grow creating more wealth for the person. This sounds great and it is easy to understand on its surface. However, the outcome of this retirement strategy really depends on the second part of the assumptions.
Therefore, the second assumption is that the person delaying the tax will receive the income from the “delayed account” in retirement when they are in a “lower tax bracket."
How much of the extra wealth is actually the account holders to keep when it is all said and done using this method? If you think about these assumptions, you will see that what a saver is really doing when they contribute to a tax deferred retirement account is borrowing the taxable portion of their income and forming a partnership with the IRS. As I mentioned earlier, the potential problem with this assumption is that the IRS has the ability to increase their claim on that pot of money anytime in the future by increasing income taxes. Will taxes increase in the future? Who knows. My opinion is that they probably aren't going to decrease but no one knows for sure.
The people who are making contributions to a tax deductible qualified retirement account are also creating a potential tax penalty for themselves if they need to withdraw the money before they are 59.5 years old. There are some ways to access this money before then. For example, a person can take a loan against a 401k balance or they can take equal annual distributions from an IRA through the use of a 72(t) distribution. Other than that, if they make any surrenders to these accounts before they turn 59.5, they will be required to not only pay the tax, but also a 10% penalty for making the withdrawal.
When an investor makes a ROTH conversion, they are actually "divorcing" the IRS's claim on their account balance. Like any divorce, a payment has to be made splitting up the assets so that each party gets their share. Once it this is complete, the account owner no longer is in debt to the IRS.
There is an additional benefit to this separation as well. After 5 years has passed from the date of the conversion, any of the money that was converted from a traditional IRA to a ROTH IRA becomes 100% available for penalty and tax free withdrawal for any person of any age. These tax and penalty free withdrawals do not include any earnings the account may experience before the owner turns 59.5 years old.
The Best Time to Convert an Account – When It's Value is at It's Lowest.
All other aspects considered, the best time to convert a tax deferred traditional retirement account to a ROTH IRA is when the account value is at its lowest.
Assets like stocks, bonds and real estate typically found in retirement accounts tend to increase in value over time. However, history shows they can decrease in value just as well.
If one does convert their IRA, the IRS has a “redo” feature allowing the account holder to switch back to a traditional IRA and avoid those converstion taxes that year. By exercising this feature, they accept that they are partners with the government again. However, it doesn't mean they can't convert again in the future, the next time at a lower rate.
Knowing that you can reverse your decision, especially when investment markets have high valuations, provides flexability and safety to the person making a conversion today.
Additional Retirement Income Tax Considerations
One of the most overlooked aspects of retirement income planning is the affects withdrawals from traditional IRA's have on the taxation of Social Security.
Social Security can be 100% tax free if planned for properly. Income from a ROTH IRA does not count towards income that increases the taxation of this benefit. In theory, a person could earn unlimited amounts from a ROTH IRA and not pay a dime in Social Security taxes creating a massive tax free retirement. Poor planning such as delaying the taxation of IRA money could make the income from Social Security 85% taxable. This could increase the amount of taxes a person pays by $100's of thousands of dollars in retirement.
They say when you put off something painful that needs to be done, it just increases the amount of pain you will feel when it is finally dealt with. Delaying the payment of taxes is definitely one of those circumstances.
What State Do You Reside In - What State Will You Retire In?
I live in Florida where there is no state income tax. Other states without an income tax are Texas, Tennessee, Alaska, Washington, South Dakota, Alaska, Nevada, Wyoming and New Hampshire. If a person lives in any of the other states that do have a state income tax, they need to consider the state tax ramifications of converting as well.
Here in Florida, I see a lot of people who have million dollar IRA's they accumulated in states like New York, Ohio and Michigan. All states that have state income taxes. Now that they have moved to a state without an income tax, converting to a ROTH IRA makes a lot of sense as that tax is no longer a consideration.
This is must know consideration if you currently work in a state that has a state income tax and plan on living in a state without one when you retire. It may be better to convert when you get to your new home. New York has a top state income tax of 9% and California is 13%. Deferring taxes while living there until you move to a state like Florida can save you a bundle!
Realize though that waiting carries the risk of an increased federal tax and its affect on the account conversion.
The Taxes Due when Making the Conversion
Current tax law states that when a traditional IRA is converted to a ROTH IRA, a person can pay the taxes due over the next two years. For example, if $10,000 of taxes are due after a conversion that happened in 2014, then $5000 can be paid for in 2014 taxes and $5000 can be paid for in 2015 taxes.
In addition, if an account value plummets after the conversion, an account owner has the ability to "recharacterize" the IRA back to a Traditional IRA so that they can recapture their tax liability. The account holder perform this process on their account anytime before October 15 of the year after the money was converted to a ROTH IRA. This is the "redo" feature I spoke of earlier.
Conclusion on Converting to a ROTH IRA
Converting to a ROTH IRA is a type of divorce between an account holder and the government's where they live. Understanding the various impacts of the conversion could provide incentive to make the conversion sooner than later.
Taking out “debt” in the form of a home equity loan in reality isn't taking on any additional debt. Instead of owing money to the government, you would instead owe money to a bank and have an asset in the form of a ROTH IRA that is 100% yours and who's original amount is100% available without tax or penalty after 5 years. In the mean time, the additional earnings can grow and create additional tax free asset value.
If a person does decide to use home equity to pay the taxes, they could delay the new loan as long as possible because the taxes are due over the next two years. This can save interest expense on the new loan. Keep in mind that the loan may not be available to you though if your income situation changes.
The loan against the home can technically be paid back after 5 years by withdrawing the principle out of the newly created ROTH IRA. Effectively, there isn't any affect on a persons net worth because this money was never truly theirs. It was borrowed money from first the government (through tax deferral) then the bank (through a home equity loan). After the conversion and all the loan repayments, a person will create a balance sheet that has less debt than it had before.
Therefore, "going into debt" to pay convert a traditional IRA into a ROTH IRA isn't really going into debt as much as it is redistributing who you owe money to while gaining control of your wealth.