Due to 2010 changes in limits on converting funds from a traditional IRA to a Roth IRA, such conversions became a good idea for many. In a divorce situation, it is important to consider this option when dividing assets. Whether in a divorce situation or not, accessing cash from the equity in your home through a refinance is an option to pay the taxes associated with the conversion.
What is a “traditional” IRA vs. a Roth IRA?
- A traditional IRA is an IRA where you invest money before you pay taxes on it. The money invested grows in the account tax-free, requiring that you pay taxes on the income earned when you withdraw the funds.
- A Roth IRA on the other hand is a retirement account where you invest after-tax dollars and withdraw the funds tax-free. Since taxes are paid on money prior to investing, you do not have to pay taxes when you withdraw the funds.
In 2010, the limits were lifted on the amount of money you could convert in your traditional IRA to a Roth IRA. This was part of the Bush Tax Cuts and potentially could be a smart option for anyone with a traditional IRA. However, there are tax implications of Roth IRA conversions, and this should be considered fully before choosing to complete a conversion.
One way to pay the taxes related to a conversion is through a “cash out” mortgage refinance, which allows access to the equity in your home.
Let’s look at an example of how to utilize a mortgage to pay for the tax bill on the conversion.
Assume that Clint and Terri are getting a divorce and they have a traditional IRA with a value of $300,000 which through the divorce settlement agreement is going directly to Terri. They are in a 33% tax bracket which would equate to a future tax liability of $99,000 for Terri. If Clint is retaining the marital home valued at $300,000 and Terri is getting the $300,000 IRA, there’s not an equitable division of assets if the future tax bill is not addressed.
$300,000 IRA amount x 33% tax rate = $99,000 tax bill
Now let’s assume that Clint wants to make sure that Terri does not have to be worried about a tax bill when she reaches retirement age and since he is working and able to afford it he wants to look at options to pay the conversion tax bill for Terri. A very smart option for Clint to find this $99,000 is to take it out of the equity in the marital home he is keeping rather than paying cash for the tax bill.
Let’s look at the financial advantage of using a mortgage to pay for the conversion. In this example, we are comparing the consequences of paying the tax bill with cash vs. paying the tax bill using a new mortgage. The amount of cash needed is $99,000 due to the 33% tax bracket. If Clint was to keep the $99,000 in his investment account earning a 6.5% return, he could earn $6,435 in income per year in the investment account. By paying the tax bill with this amount, he in effect would lose the potential to earn this amount, thus $6,435 is the annual Opportunity Cost.
When Clint takes out a new mortgage where he gets the $99,000 cash out of the equity in the home, assuming an interest rate of 4.5%, his after tax mortgage cost is actually only 3.015%. This is because Clint is in a 33% tax bracket. (The after tax mortgage rate is a simple calculation of 4.5% x (1-33%) = 3.015%.)
Assuming a 30 year fixed rate loan, the annual after tax cost of the interest is $1718; when compared to the opportunity cost of potential investment returns, Clint will “save” $4717 per year over those 30 years.
As mentioned earlier, a ROTH IRA Conversion may be a smart choice right now for anyone regardless of whether or not they are going through a divorce. A conversion benefits anyone who wants to convert some or all of their traditional retirement account funds into a Roth IRA while there are no limits to the amount you can convert.
If you are interested in a mortgage refinance to pay for a Roth IRA conversion, please contact me for a mortgage refinance quote and analysis.