Roth IRA conversion to spread out taxes?

[Katsmeow]

I have read a few threads here on converting a regular IRA to a Roth IRA and wonder if something is feasible or if there are loopholes that make this not idea not feasible. We've never had a Roth IRA as we have always been above the income limit for contributions. DH recently retired and is soon to receive a lump sum on his pension (this is just over a million). The lump sum is being paid sent directly to an IRA at Vanguard.

Making a long story short, we are building a new house. Projected cost to prepare the land we owb and to build is about $280,000. The source for this cost is the IRA that his lump sum is in. We anticipate paying about $100,000 of that $280,000 this year and the rest during 2010.

I am looking for ways to lessen the income taxes on the money that has to be taken from the IRA to do this. I wonder if a Roth conversion is possible and would help.

For this year, we are very close to the 35% tax bracket even before taking out the additional $100,000 this year. If we take out $280,000 for next year between that, the taxes that will be owed on it and other income we will be in the 35% tax bracket.

For 2011 and on we will likely be in the 25% bracket assuming I continue working.


So -- with that background:

Could we convert the money to build the house to a Roth IRA this year, withdraw it this year and next year to pay for the house, and then spread out the taxes over 2011 and 2012?

DH is over 59 1/2. Given that is he free to immediately after converting withdraw contributions from the Roth IRA (he would leave in any earnings)?

If this is feasible the attractive part of it is that it keeps us out of the 35% bracket in 2010 and 2011 although it does keep us in the 33% bracket for 2011 and 2012. However, it defers paying those taxes for quite some time.

Potential downsides:

I can't really invest the money that I am holding back to pay those taxes in anything very risky since I have to be sure it is available to pay taxes. So, defering paying the taxes doesn't help me earn all that much money.

Tax rates could go up.

​

I am also unsure if I should just convert the money to build to house and then withdraw taxes from the regular IRA at the time paid or whether I should convert taxes now. I am inclined to not convert all the taxes now since if I may be able to defer some of the taxes even until 2013 (i.e. making minimum required estimated taxes in 2012 and then paying rest in 2013).


Does doing an IRA conversion for, say, $325,000 work?

 

[LOL!]

There would be virtually no benefit to convert to a Roth in your scenario. Here's the options:

1. Convert some to Roth. Pay income taxes on the conversion. Stuff into a money market fund since you need the cash for the home. You need to keep the converted money in a Roth for a while (5 years?) before you can remove the gains tax-free. So taxed on gains (if any) from the money market.

-or-

2. Withdraw money from the IRA to pay for new house expenses. Pay income taxes on the withdrawal. Guess what? The amount of income should be identical to the Roth scenario.

So you do not gain anything at all. You would gain by spreading out withdrawals over a few years. Thus a construction loan or mortgage might save you tons of money if the payments were spread over many years. Mortgage rates are so low now, it might make stupendous sense to get one of those 4.2% mortgages or even a 5-year balloon mortgage.

Another thing to consider is that the taxes on a conversion can be spread out over 2 years, but be careful about the tricky 5-year rule which I am sure someone will come along and [-]correct me[/-] explain in a moment.

 

[Katsmeow]

Withdraw money from the IRA to pay for new house expenses. Pay income taxes on the withdrawal. Guess what? The amount of income should be identical to the Roth scenario.

I agree that the amount of income on just withdrawing it out of the IRA would be as if I did the Roth conversion. The question for me is this. If I just withdraw from the IRA I have to withdraw about $100,000 for what I will to spend this year for the house construction (plus the applicable taxes). All of that will be at the 35% marginal tax rate. Next year I would withdraw the other $180,000 plus the taxes on that. Part of that would be at the 33% marginal tax rate and the rest at 35% (that is at current rates, there is a good chance those tax rates will end up being 36% and 39.6% in 2011 and forward).

If I do the Roth conversion the I pay half the taxes in 2011 tax year and half the taxes in 2012 tax year. For 2012 a good part of the money will be taxed at the 28% tax rate (but some at 33% most likely as well -- again that may be 36% rate by then).

Getting a loan to spread this out is not feasible at this time. First, we would have to sell our current house first (it has a mortgage on it). It is on the market and could sell. If it does then we might consider a small mortgage although qualifying could be an issue (while we have assets only income is DH's SS income and my part time income).

Right now the negative of our existing house it is expensive to maintain and has a mortgage. So we want to sell it. We are getting fairly good showing activity and have had a couple of people highly interested in it (but typically they need to sell their house first).

On the other hand, we had several dogs and cats which we can have in our current house. If we were to sell it tomorrow we might be able to get a loan to pay part of the cost to build the new house. However, we would then need to rent for about 10 months during construction of the new house. It is highly unlikely that we can find a rental that will allow us to have all our pets there (most subdivisions limit people to 2 to 4 pets -- we have 7). Assuming we could find a rental that allowed us to have 4 pets we would have to board 3 at a cost of about $1000 a month. If we have to board 5 it is closer to $1500 a month. So, renting is also quite expensive giving the pet issue.

So, in some ways it isn't any more expensive for us to live in current house as it would be to have a rental given the pet expenses. But, while we own this house we couldn't get a mortgage.

It is very difficult to know what works out the best economically to minimize taxes in our situation.

 

[growing_older]

This sounds tricky enough that you have to have all your plans work out just right - plus you need to be really sure that the tax laws work the way you think they do. As I understand, conversions this year (and this year only) can be declared as income half in 2011 and half in 2012. So I think this is what you hope to do with the conversion, followed by almost immediate withdrawal from the Roth. Very clever and probably a loophole that wasn't anticipated. I'm surely not expert enough to comment on the details, but this is how I also thought it was supposed to work. I doubt many people will be in a position to take advantage of this particular feature of the law.

 

[Katsmeow]

Yes, growing_older, that is exactly what I'm thinking of doing. I still need to model the results to see if it makes any sense (assuming I can do it).

 

[chinaco]

I reread the post and figured out you were describing taking advantage of the 2010 loophole.

You need to run the numbers. But it will depend on what happens with the pending tax legislation. Your marginal income tax rate may go up... especially if you are in the upper tax brackets.

You may not get a preview of the tax law changes before the year ends since there is much debate about it. Congress could wait till after the election (i.e., next year).

 

[Katsmeow]

Yes, Chinaco, I am basically trying to figure out if I can take advantage of the 2010 loophole to allow spreading out of taxes over 2011 and 2012. If so, then I have to decide if that is advantageous. Tax laws being changed are what I'm afraid of. That I would have to convert before knowing what happens with taxes. I've read what the administration proposal is so can model that. But they could end up doing something I can't predict.

 

[LOL!]

Frankly, I don't think paying 33% to 35% income tax on a withdrawal is such a smart decision. It does not matter if you pay the tax in 2010, 2011, or 2012.

It sure seems to me that you should talk to a mortgage broker or your banker about this situation rather than just say "We can't get a mortgage now". If you can envisage being in the 28% or 25% tax bracket without the IRA withdrawal, then perhaps you can get the builder to lend you the money in a so-called construction loan. You would not get a conventional mortgage, but would be looking for something so save lots on your taxes. Even a 5-year loan at a 7% or 8% interest rate with a balloon payment might be better than what you plan to do. You gotta think outside the box on this.

Indeed, if you tell the builder, "We can't do this without a loan, stop construction", you might be surprised how quickly they can accommodate you.

 

[Katsmeow]

Frankly, I don't think paying 33% to 35% income tax on a withdrawal is such a smart decision. It does not matter if you pay the tax in 2010, 2011, or 2012.

It sure seems to me that you should talk to a mortgage broker or your banker about this situation rather than just say "We can't get a mortgage now". If you can envisage being in the 28% or 25% tax bracket without the IRA withdrawal, then perhaps you can get the builder to lend you the money in a so-called construction loan. You would not get a conventional mortgage, but would be looking for something so save lots on your taxes. Even a 5-year loan at a 7% or 8% interest rate with a balloon payment might be better than what you plan to do. You gotta think outside the box on this.

Indeed, if you tell the builder, "We can't do this without a loan, stop construction", you might be surprised how quickly they can accommodate you.

We currently have a loan on our existing house. I know that with that loan we can't get a mortgage. It isn't close. The builder does not do loans.

If we pay cash for the construction we do get a 2% discount on the construction of the house. One thing I have thought if is that if sell the existing house during construction, then I wonder if we could get a loan for the remaining (the deal is that we pay 1/3 basically when construction starts, 1/3 when house is dried in, and 1/3 when completely finished.

If we sold existing house after the first 1/3 of was paid but before rest was paid we might could get a loan for that part (although we would have to give up our 2% cash discount).

 

[ERD50]

We currently have a loan on our existing house. I know that with that loan we can't get a mortgage.

Can you refi larger mortgage on your existing hose, and use that to pay the builder?

I agree with others that it really looks like you need to level-load your taxable income to avoid those higher brackets.

Side Note: Another unintended consequence of income tax.

-ERD50

 

[Katsmeow]

I can't refinance the mortgage because (1) we no longer have the income to qualify for it and (2) we have very little equity. The only way to do a loan would be to sell the existing house. It is on the market now.

If we drop the price to try to sell quickly we also have to consider what happens then. We would need to rent while building. Because of our number of pets we would probably have to board some of our dogs so the net cost of renting + boarding dogs may be almost as much as we are paying to live in current house.

Also for various timing reasons we want to start building the house this fall so that it is finished by next summer. I do wonder if we start building it for cash (builder would get 1/3 when we start) and then we later sold the existing house, could we then get a loan for the other 2/3 of the cost? The builder doesn't require a construction loan, just a commitment from a lender to loan the money when the house is completed.

If could get a loan (if even for the last 2/3 of the house) then we could spread out paying for the house over a time of our choosing depending on tax rates. I just don't know if we could get a loan if we started building for cash and then sold existing house and could seek loan at that time?