Let Your House Pay for Your 2020 Roth IRA Conversion
Reprinted with permission from Forbes.com where Jim is a regular contributor.
2020 may be the best year to make a Roth IRA conversion. One obvious reason is that the CARES Act temporarily suspends Required Minimum Distributions (RMDs) from traditional IRAs and retirement plans for IRA owners 72 or older—but this is only true for 2020. If you don’t take your RMD this year, your income will be reduced which, by itself, would possibly make 2020 a great year to make a conversion. If you were already thinking about a conversion, you might be able to make a larger one and stay in the same tax bracket. For many older IRA owners, 2020 could be their lowest-income year for the rest of their life.
Let’s assume you are a good candidate for a Roth conversion before the end of the year. The easiest decision will present itself for individuals who will be in a lower tax bracket this year and who have the money to pay the taxes on the conversion from outside of their IRA. That is, they would use some of their “after-tax” or non-IRA money to pay the taxes on the conversion.
At the next level, it gets more complicated. If you must pay the taxes on the conversion from the IRA itself, then a Roth conversion is not nearly as favorable. Sometimes using IRA money to pay the tax on a Roth IRA conversion is still favorable, but the math is much less compelling than if you have after-tax dollars to pay the tax on the conversion.
If you find yourself in this position, you will ideally find a nontaxable source of money to pay the taxes on the Roth IRA conversion. Let me propose an idea.
Assuming you have no immediate plans to sell, I suggest you consider letting your house pay the taxes on the Roth conversion. Mechanically you would borrow the funds from a bank to pay the taxes on the conversion and put your house up as collateral. Current interest rates are quite low. You can get a home equity line of credit if you are thinking of a series of Roth IRA conversions.
The money from the loan pays the taxes on the conversion. You now have a Roth IRA growing tax-free without incurring taxes from cashing in the traditional IRA to free up the money to pay for the conversion.
Most people balk at this suggestion. I get it. It is a lot easier for our firm to “crunch the numbers” than for you to go out and borrow against your house. I always say for a tax strategy to work, it must pass the “math test” and the “stomach test.” We have “crunched the numbers” enough to know that for many IRA owners, this strategy passes the math test. The financial difference it could make for your children over their lifetimes could easily amount to hundreds of thousands of additional dollars compared to not making the conversions.
But that doesn’t mean it passes the stomach test. Can you stand owing money on your house again without losing sleep? You slaved for years with the goal of paying off your house and you finally did it. Now, some number cruncher armed with a bunch of spreadsheets is saying you and your heirs will be better off if you make the conversion or series of conversions and have your house pay the taxes. The stomach test must be considered.
Please don’t utilize this strategy if you don’t have a good way of making payments on the loan even if the market takes a substantial hit. Most IRA owners will experience a higher minimum distribution as time goes by. Often, that distribution when added to their Social Security exceeds their living needs. At that time, the line of credit could be paid off.
Could this strategy hurt you if the market goes down? Well, yes, but that would be true of any Roth IRA conversion. And the market must go down and stay down for you to be hurt in the long run. If interest rates go up, you could also get hurt, but remember, I am assuming that you could pay off the loan from cashing in your IRA if you wanted to.
Before you act, I recommend you consult with a trusted advisor who can fully analyze your financial position and “run the numbers” to help with your decision.
For many taxpayers, now might be the best time in history to execute a Roth IRA conversion. I respectfully request that you keep an open mind to doing a Roth IRA conversion and letting your house pay the taxes.
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