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Roth IRA Conversion: Good Idea??
Old 03-04-2013, 05:46 PM   #1
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Roth IRA Conversion: Good Idea??

Background info:
Married, wife pregnant with one child
Ages 35, 33
Income: Joint gross for 2012 $306,000
Goals: Be able to retire in 50s (15-20 years)

Current Savings (only been working 1 year) - Emergency Fund $25,000; traditional IRA $23,000; 401K $35,000; Taxable Account $7000

Currently saving: $100,700/year ($17500 401K contribution, $5200 employer match, and $78,000 taxable account)

Debt:
Interest free mortgage (you read that right, parents loaned us the money interest free!) $304,000 - make biweekly payments of $1300, will be payed off in 9 years (I know it's interest free but hate debt)

Student loan: $30,000 - plan to pay off over next 9 years

Investments Mix: Right now, pretty basic as I do not know a lot; 401K is 100% S&P index fund; taxable is 100% VTWSX, and IRA is 100% VTWSX. Basic plan is to pour money into these until debt-free (9 years) and then start allocating to bond funds for a more suitable retirement mix.

Questions:
I have been considering converting my IRA to a roth IRA, then opening up a IRA for my wife, and then doing a backdoor Roth Conversion for each of us each year starting in 2013.

Do I have to pay taxes on the 23,000 in my IRA as soon as I convert it?
Any reason not to do the conversion? From my reading it seems like a no brainer since I do not have a lot in the IRA now.
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Old 03-04-2013, 06:53 PM   #2
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In general, conversion makes sense only if you expect to be in a higher tax bracket during withdrawals. A few other special cases can apply that encourage conversion. One is if you have after-tax contribs sitting in a tIRA. Any tax on a conversion to Roth is due with your next annual tax return, but since the conversion counts as ordinary income it may increase estimated taxes due before you file your 1040.
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Old 03-04-2013, 06:57 PM   #3
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(You may not want to speak too loudly about a 0% private mortgage as the IRS may challenge a mortgage that is at significantly below-market rates.)
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Old 03-04-2013, 08:02 PM   #4
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Did you deduct your tIRA contributions in the years that you made them? If yes, then you will pay tax on the full 23K in the year you do the conversion. If you didn't deduct the contributions then you'd have a basis in the tIRA and only the earnings that are converted would be taxable.

Normally, you wouldn't want to convert to a Roth in your tax bracket. But, given that it's a small amount (compared to your income), I like your plan to convert all of the tIRA to a Roth and start doing backdoor contributions/conversions for both of you starting next year (or this year if you haven't made contributions yet).
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Old 03-04-2013, 08:15 PM   #5
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Originally Posted by GrayHare View Post
(You may not want to speak too loudly about a 0% private mortgage as the IRS may challenge a mortgage that is at significantly below-market rates.)
+1 on that.

You may want to engage a professional for an opinion on this -- a legal way to accomplish the same thing, if that is possible.
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Thanks for replies.
Old 03-04-2013, 09:05 PM   #6
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Thanks for replies.

The Traditional Ira is a rollover Ira from the 401k at my previous employer, so all the money is pre-tax. But since it is such a small amount it seems to make sense to do the conversion now, before any more contributions are made. That way, we don't pay taxes on that money ever again and have a place to shelter some of our bond funds in the future. Seems like this is what I should do.
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Old 03-04-2013, 09:23 PM   #7
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There is something called the AFR ( applicable federal rate) that establishes interest rates to be charged for loans between individuals.
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Old 03-04-2013, 09:24 PM   #8
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He means if your parents gave you money, they can only give you $13k(or whatever it is today) a year, so $26k per year without having to file a gift tax return.

If they want to give more, they have to file a 709. Lifetime exemption is $1 million( or whatever the hell current exemption rate is in 2013).

If they aren't charging you market rate interest rate, then it's a gift...so they have to file a 709 and use their lifetime exemption.
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Old 03-04-2013, 09:26 PM   #9
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If the "gift" was above the annual gift tax exemption, your parents needed to do some paperwork with the IRS (form 709) so the IRS would know they used some of their lifetime gift tax exemption.

If the money they provided you to buy the house was meant to be paid back (was not actually a "gift") then the comments about a 0% private mortgage might apply.

In relatively small amounts, this likely isn't the kind of thing the IRS spends a lot of resource delving into. But, since it's tax season, if you pay a professional to handle your taxes you might want to ask about the situation.

Edit: comicbookgujy and I were typing at the same time. Yes to what he said.
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Old 03-04-2013, 09:30 PM   #10
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Quote:
Originally Posted by Relaxed Cajun View Post
Debt:
Interest free mortgage (you read that right, parents loaned us the money interest free!) $304,000 - make biweekly payments of $1300, will be payed off in 9 years (I know it's interest free but hate debt)
Unfortunately TANSTAAFL...
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Old 03-04-2013, 09:31 PM   #11
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The IRS makes a distinction between bona-fide intra-family loans and gifts. Depending on amount in question there may be gift tax ramifications for no interest loan. Google "Applicable Federal Rate Intra-family Loan" . One result is here: Intra-family loans
Can't vouch its accuracy or its applicability to your situation, but it could be a concern.
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Old 03-04-2013, 09:38 PM   #12
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Agree with the tax implications on the loan. The IRS will imply an interest rate on the loan and can assess the amount back to you that you saved as income.

Go seek a professional to check better ways for the gift.
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Old 03-04-2013, 09:39 PM   #13
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Originally Posted by Relaxed Cajun View Post
Background info:
Married, wife pregnant with one child
Ages 35, 33
1. You're young. Money converted to a Roth now has time to grow. Earnings come out of a Roth tax free just like the contributions. Say you convert $10K now. You pay tax on $10k as ordinary income. 30 years from now the $10k has doubled twice and is now $40k. All $40k comes out tax free. Time is on your side.

2. You have a child on the way and might have more. Roth IRA's make wonderful inheritances for the kiddos if it turns out you don't spend it yourselves.

Despite the fact that the conversions will be expensive due to your income and resulting high tax bracket, I'd do some due to your young age and the opportunity to have tax free earnings come out in retirement or for your kids to inherit. And yes, do back door Roth's going forward.
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Old 03-04-2013, 10:35 PM   #14
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On your mortgage, if your itemized deductions don't totally phase out given your high income, you may be better off paying interest to your parents and taking the deduction. While they would have to declare the interest as income presumably they are in a lower tax bracket than you are. If that is the case they could then gift to you an amount equal to the after-tax interest on the loan.

So let's say you pay them $15k of interest next year and you get a $5k tax benefit because you can deduct the $15k. And they claim the $15k as income and pay $3k in taxes on that incremental income. They gift $12k back to you. So by arbitraging your differences in tax rates you come out ahead by $2k and are on more solid footing with the IRS.

YMMV. It would typically be beneficial only if your marginal tax rate exceeds your parents and you can benefit from the mortgage interest deduction.
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Old 03-05-2013, 12:00 AM   #15
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Quote:
Originally Posted by Relaxed Cajun View Post
The Traditional Ira is a rollover Ira from the 401k at my previous employer, so all the money is pre-tax. But since it is such a small amount it seems to make sense to do the conversion now, before any more contributions are made. That way, we don't pay taxes on that money ever again and have a place to shelter some of our bond funds in the future. Seems like this is what I should do.
Will your current 401K accept these pretax funds? If you "hide" them inside another 401K, then your non-deductible TIRAs could be converted w/o tax.
see last 2 paragraphs of step 1 The Tax Cost of Converting to a Roth
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Old 03-05-2013, 10:48 AM   #16
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Will your current 401K accept these pretax funds? If you "hide" them inside another 401K, then your non-deductible TIRAs could be converted w/o tax.
see last 2 paragraphs of step 1 The Tax Cost of Converting to a Roth
While I don't understand why anyone would get excited about doing a Roth conversion in the OP's tax bracket, another option is to "hide" the funds in a solo401k. DW and I have a legal and legitimate business where I am considering opening up a solo401k to take my rollover IRA. For now, years in which I am over the Roth IRA contribution income limit, just DW contributes, but even then I hardly get excited about it. But when faced with Roth or a taxable account, the choice is clear (for me at least).
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Old 03-05-2013, 11:33 AM   #17
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In your situation I would do it - the tax on the conversion is a small price to pay for being able to do the backdoor Roth's every year. It's surprising how quickly $10k a year adds up in a Roth (assuming your wife has earned income and can also contribute).

There's also some misinformation flying around regarding the mortgage. There are two elements to this - an income tax and a gift tax side. The income tax is the imputed interest on the loan between you and your parents. If you treated it as a demand loan then you can use the short term AFR of around 0.2% right now, so on a $300,000 mortgage that is interest of $600 per year. Your parents should be reporting this as interest on their tax returns (and you can take a deduction provided the loan is secured on the house), but I don't think the IRS would be too concerned about $600 per year. That rate has to be reset annually so eventually the rates might rise enough to start to be significant.

The gift tax element is that you are treated as paying the interest to your parents and they gift it back to you. But since the intreest is well below the annual exclusion amount of $14,000 (per individual), that's not something you need to be concerned about.
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Old 03-05-2013, 02:39 PM   #18
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...If you treated it as a demand loan then you can use the short term AFR of around 0.2% right now, so on a $300,000 mortgage that is interest of $600 per year. Your parents should be reporting this as interest on their tax returns (and you can take a deduction provided the loan is secured on the house), but I don't think the IRS would be too concerned about $600 per year. That rate has to be reset annually so eventually the rates might rise enough to start to be significant.

The gift tax element is that you are treated as paying the interest to your parents and they gift it back to you. But since the intreest is well below the annual exclusion amount of $14,000 (per individual), that's not something you need to be concerned about.
But if it was beneficial to them they could restructure it as a regular amortizing loan and use a market interest rate (say between 3 and 4%) and then have the parents gift back to them the interest net of taxes the parents pay, couldn't they?
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Old 03-05-2013, 02:48 PM   #19
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Unfortunately TANSTAAFL...
i'm dumb. what does TANSTAAFL mean
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Old 03-05-2013, 02:52 PM   #20
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You could always Google it...
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