Nathan and Stacey Zee
Should we borrow to pay the tax on a Roth IRA conversion?
Nathan and Stacey, federal workers in their thirties, are excited about the prospect of transforming their already sizable IRAs into tax-free retirement income. But the price could be steep. It will cost about $100,000 in federal and state taxes to convert the $250,000 they have stashed in their traditional IRAs to Roth IRAs this year, when income limits on conversions disappear.
The Zees are thinking about borrowing on their home equity to pay the taxes. Is that wise? And when should they pay the tax bill? Nathan and Stacey know that if they report the entire conversion on their 2010 return, the extra income will boost them into the maximum 35% federal bracket. Their alternative is to use the one-time opportunity to split their tax bill between their 2011 and 2012 returns.
Think it through. Anthony Christensen, president of Access Wealth Management, in Louisville, Ky., says the Zees should definitely convert all their IRA money to Roths. “The Roth IRA is almost the only way to earn tax-free money without going to prison,” quips Christensen. But he doesn’t recommend that Nathan and Stacey, who have an infant daughter, Rachel, leverage their future to do so.
Because the Zees have two incomes and prodigious savings habits, Christensen thinks they could pay the tax out of current cash flow. If they set aside $2,000 a month and defer the first tax payment until their 2011 return, they could have $56,000 (before interest and taxes) saved by April 2012, the due date for their 2011 tax return. That’s more than enough to pay the first half of the tax bill.
Christensen thinks it would be better to risk paying a bit more if tax rates go up than to draw $100,000 on a home-equity line at a variable interest rate (recently 4.5%), even though the interest would be tax-deductible.
Another view. Mitch Drossman and Lester Law, wealth strategists for U.S. Trust, Bank of America Private Wealth Management, think Nathan and Stacey should convert a little of their traditional IRAs to Roths each year, paying the tax as they go, without mortgaging the house or draining their savings. “We don’t think they need to rush into this,” says Drossman. “They’d be giving up a heck of a lot of flexibility to do it all at once.”
But even if the Zees decide to convert all their IRA money to Roths in 2010, they have until October 15, 2011, to change their minds. At that point, it should be clear what Congress intends to do with future tax rates, says Law, and they can decide whether to report all the income from their conversion on their 2010 return or split it between their 2011 and 2012 returns.
That same grace period offers them an extra safeguard in the event the value of their IRAs falls below the level when they converted in 2010. Rather than paying tax on the higher, phantom value, they can undo the conversion without owing any tax and reconvert sometime in the future.