What is a Roth IRA?
A Roth IRA 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 don’t have to pay taxes when you withdraw the funds!
In 2010, as part of the Bush Tax Cuts, the limits were lifted on the amount of money you could convert in your traditional IRA to a Roth IRA.
ROTH IRA Conversion is 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.
Using 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.
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 would lose $6,435 per year in income in the investment account (Opportunity Cost).
When Clint takes out a new mortgage where he gets the $99,000 cash out of the equity in the home at 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.
Regardless of how you calculate the after-tax mortgage interest rate on $99,000 the after tax mortgage cost of borrowing the $99,000 is only $3,118 during the life time of the loan. This equates to an annual benefit of $3,317 per year and appears to be a very smart option for Clint to pay the tax bill for Terri.
*Information courtesy of Divorce Lending & Real Estate Association*
As mentioned earlier, a ROTH IRA 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 have questions about this topic or are need guidance in your own mortgage refinancing, email John or give him a call at (512) 524-8310.
This is for informational purposes only and not for the purpose of providing legal or tax advice. You should contact an attorney or tax professional to obtain legal and tax advice. Interest rates and fees are estimates provided for informational purposes only, and are subject to market changes. This is not a commitment to lend. Rates change daily – call for current quotations.
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