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 an example where you have a conventional retirement account worth approximately $300,000. If the value of your account increases by an average of 6% per year over the next 5 years, your account would be worth $400,000. You would need to pay taxes when you retire and withdraw the $400,000 from the account. Assume you are in a 24% income tax bracket. When you withdraw the $400,000, you would need to pay $96,000 in taxes (24%). If you leave the money in the account to be inherited by your heirs, they would need to pay income taxes on the money when they take distributions. They would be required to take distributions within 10 years according to the new SECURE Act which went into effect January 1, 2020. 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 would not need to pay any taxes at all when you retire and withdraw the funds. However, you would need to pay taxes now on the $300,000 ($72,000 in taxes assuming a 24% tax bracket).  In this example, you would save at least $24,000 in taxes by paying the 24% tax now on the $300,000 account value instead of later on the $400,000 account value. Your savings would 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.


Where to get the money for the tax bill?

In our example, you would need to pay approximately $72,000 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 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 $72,000 $72,000
Opportunity Cost % 6% -
Opportunity Cost $ (what you would have earned by keeping your money invested) $4,320 -
After-tax Mortgage Cost % (based on 4% mortgage rate) - 3.04%
After-tax Mortgage Cost $ - $2,189
Annual Benefit - $2,131/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.

Source: CMPS Institute