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How to Finance the Roth IRA Conversion Strategy


What is a Roth IRA?

A Roth IRA is a retirement account where (1) you invest your money after you've paid taxes on it, and (2) you can withdraw your money without paying taxes on the withdrawals.

Traditional IRA Roth IRA
Invest money before you pay taxes on it Invest money after you pay taxes on it
Grow the money in the account tax-free Grow the money in the account tax-free
Pay taxes when you withdraw the funds No taxes when you withdraw the funds
What if you leave the funds in your traditional retirement account?

Consider a situation where you have a traditional retirement account worth approximately $300,000. Assume the market goes up by an average of 6% per year over the next 5 years and your account goes up in value to $400,000. You will need to pay taxes when you withdraw the $400,000 from the account. Assume you are in a 33% income tax bracket. Do you think your tax bracket and/or the income tax rates in the future will be higher, lower, or the same as today? Most people would agree that tax rates will probably be higher - especially given the enormous US federal budget deficit. Even so, let's assume your tax bracket in the future is the same as today, around 33% in our example. When you withdraw the $400,000, you will need to pay $132,000 in taxes (33%). If you leave the money in the account to be inherited by your heirs when you die, they will need to pay income taxes on the money when they take distributions, and they are required to take distributions over their life expectancy. They also might need to pay estate taxes on the funds, depending on the value of your estate.

Why Convert the Funds from a Traditional IRA into a Roth IRA?

In the example above, let's assume you convert the $300,000 into a Roth IRA. In this case, you will not need to pay any taxes at all as you withdraw the funds when the account goes up in value to $400,000. However, you will need to pay taxes now on the $300,000 ($99,000 in taxes assuming a 33% tax bracket).  In this example, you would save at least $33,000 in taxes by paying the 33% tax now on the $300,000 account value instead of later on the $400,000 account value. Your savings will be even greater if tax brackets are higher in the future and/or if the retirement account goes up in value more than expected. If you don't take the distributions yourself, the funds will be distributed income tax-free to your heirs. If the market goes down, and the account loses value after the conversion, you could simply change your mind, "re-characterize" the account, and then convert the funds again later at the lesser value. This would save even more money in the upfront taxes that would be due.

Where to get the money for the tax bill?

In our example, you would need to pay approximately $99,000 in taxes to make the strategy work. You could pay the taxes out of the retirement account itself, but that would almost defeat the purpose of the conversion.  Instead, it may be smarter to take advantage of the record low mortgage rates that are currently available. You could bump up the balance on your home mortgage, and use the extra funds to pay the taxes on the conversion:

  Pay Taxes Using Cash on Hand Pay Taxes Using Mortgage
Funds Needed $99,000 $99,000
Opportunity Cost % 6% -
Opportunity Cost $ (what you would have earned by keeping your money invested) $5,940 -
After-tax Mortgage Cost % (based on 5% mortgage rate) - 3.35%
After-tax Mortgage Cost $ - $3,317
Annual Benefit - $2,623/year

As a mortgage professional, I work together as a team with your financial advisor to help you evaluate your mortgage options in the context of your overall financial goals. Let me know if this idea is something you'd like to consider in more detail!

PLEASE NOTE: THIS ARTICLE AND OVERVIEW IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY.  IT IS NOT AN ADVERTISEMENT FOR A SPECIFIC MORTGAGE PROGRAM OR INTEREST RATE.  IT DOES NOT CONSTITUTE LEGAL, TAX, OR FINANCIAL ADVICE. PLEASE CONSULT WITH A QUALIFIED TAX AND INVESTMENT ADVISOR FOR SPECIFIC ADVICE PERTAINING TO YOUR SITUATION.