How would you play this hand?

[BizzyC]

Hi all,

Long time lurker, almost never poster.

I’m looking for advice and thoughts on the weird financial hand I’ve been dealt. It’s not a bad hand, just, unusual I think. The first thing I need to get out on the table is that knowledge of tax rules is an absolute Achilles tendon for me. Several decades ago I made an inadvertent error when filing my taxes, got audited, fined, etc., and I’ve been terrified of taxes ever since. Have either paid to have them done or my spouse did them every year since then, so in your responses please assume you’re talking to a tax moron.

Anyhoo, here’s where I’m at. I divorced in May of this year. I am retired, and have been since 2014. I just turned 55.

I own a house. Zillow thinks the house is worth $3.1M. I owe $662k on the mortgage. My mortgage rate is 3.5%. I have a renter who pays me $2800/mo.

I have two 401k accounts that have a total of ~$1.3M in them, and a brand new Roth with ~ $20,000 in it. I will pay the taxes on the $20k Roth conversion out of pocket.

I have ~$450k liquid-ish assets (bank accounts, random stock in an Etrade account).

I have an equalizing payment due from the divorce of $470k. When that happens, my liquid-ish assets are going to be ~$920k. So one way to look at this is, this is awesome, I have lot of liquid cash during this period of economic uncertainty so good security. Another way to look at this is, this is terrible, because the kinds of low risk investments (FDIC insured) I’d like to find for that money are only offering very low interest rates. As of this writing, the equalizing payment is overdue, so right now, I’m actually getting 10% interest paid monthly. I have no control over if/when this changes and I get the full payment, but my guess is it will probably change within a few months.

Although it’s a little early on, I’ve been keeping very detailed records of my spending, and I think my yearly outflow is about $110k. (That figure does not iaccount for the rent I collect. I just want a little buffer in case the rent money goes away, or if I messed up accounting for something.) So in my mind, I think of my liquid-ish assets as covering my spending for about 10 yrs. It will be critical that I manage the money so that I can cover my spending for at least 4.5 years when I will be 59.5 and can tap my 401ks. I think of the equity in the house as eventual cash reserves, because this house would be too much for me to keep up with when I get older.

So here are some specific questions I have for the group.

Any way you slice it, I’m on ACA for health insurance next year. The question is whether it makes more sense for me to keep my Roth conversions low enough to qualify for the subsidy, or whether I’d be better served to forego the subsidy and convert to the top of the 22% or 24% tax bracket. The specifics for the ACA for next year are: Either $939/mo without the subsidy, or $530/mo with the subsidy. If I take the subsidy, it saves me $409/mo == $4908/yr. If I forego the subsidy, and convert to the top of the 24% bracket (single) of $85,526, my wild a$$ guess at how much I could convert is:

$85,526 = $36,000(rental income) + $18,400(2% return on invested $920k) + Roth conversion amount – $24,000(house interest paid)-$12,400(personal deduct)

Am I even figuring that out right?

Do you see other ways to play this hand that I’m not thinking of? I would love to refinance to a lower rate, but the banks are kind of idiots as soon as they hear “not working”. They refuse to consider the rent income because it is stemming from renting a room in my personal residence as opposed to being a separate rental property. Does anyone know, if I wait until I get the equalizing payment and literally have more than the outstanding mortgage amount sitting in my bank accounts, would that get them to budge on refinancing?

Any advice appreciated.

 

[wolf]

If you live in CA. Your my neighbor. Anyways, IMHO, I"ve found I get more responses, if I try and be as concise as possible.

It's well known, Banks prefer earned income. Rental income is not as "secure", so is given less "weight" by banks. Also, not a surprise.

 

[BizzyC]

Hi Wolf,

Yup, CA. Guess the housing prices kinda give it away. Sorry for the wordiness. My main interest is if folks think I'd be better served foregoing ACA subsidies to do more Roth conversions.

Regarding the banks preferring earned income, what you say is true, they do prefer "earned" income. And in the case of comparing potential income that may come from rental income, or may come from a job, I could certainly see why the income from a job would be more secure. My complaint is that they seem to prefer earned income from a job over cash already sitting in the bank. An employee may get fired or laid off, in which case much less money will be coming in and there may be risk that the mortgage is not paid. Why banks prefer this lending scenario over the scenario where the assets are already sitting in the bank, I cannot understand.

 

[calmloki]

We are both security oriented, her more than me, but I like to see money working. Not being brilliant investors we just paid down our mortgages ASAP. Maybe throw $300k at the PRINCIPAL on your mortgage. That would be like earning 3.5% on your money and still have you paying over $12,600 in interest which you can perhaps write off on your taxes.

 

[pb4uski]

...Am I even figuring that out right? ...Any advice appreciated.

Close, but not totally right.

The top of the 22% tax bracket in 2020 is $85,525 and the top of the 24% bracket is $163,300. The standard deduction is $12,400 and you can deduct $300 for contributions under the CARES Act (I assume that with your wealth you make more than $300/year in charitable contributions).

I assume that you are filing a Schedule E for the rental income and that is why you are deducting the $24,000 of house interest? Only a portion of the interest can be deducted.... but you can also deduct a portion of property taxes, insurance, etc. Also see https://www.nolo.com/legal-encyclopedia/tax-issues-when-renting-out-room-your-house.html You may also qualify for an additional 20% exclusion of your profit. So, you'll need to dive into the details on your rental activities, but for discussion purposes let's assume that it all nets down to the $12,000 that you used in your example.

So the total income that you could have at the top of the 22% tax bracket is $98,225 ($85,525 + $12,400 standard deduction + $300 contributions deduction). Subtract out $12,000 of net rental income and $18,400 of interest and that would leave room for $67,825 of Roth conversions. If you want to go to the top of the 24% tax bracket you could do as much as $145,600

Interest.................. $18,400.....$18,400
Net rental income.......12,000.......12,000
Roth conversion..........67,825.....145,600
Total income...............97,825.....176,000
Contributions deduction..(300).........(300)
Itemized deductions...(12,400)....(12,400)
Taxable income..........$85,525...$163,300

The above is based on 2020 tax brackets and standard deduction. If you're doing this figuring for 2021, the top of the 22% and 24% bracket and standard deduction are a little higher and the charitable contribution deduction might not apply. If you are going to keep your $920k invested in cash, 2% might be a bit ambitious. And of course, you need to work through the details of the rental income. Finally, you can have a plan and do a good portion of the Roth conversion early in the year (and pay the estimated tax) and then top it up with another conversion late in the year when you have better estimates of what your final tax situation will look like.

Also a good friend for looking at various alternatives is the TurboTax What-If worksheet if you do your own taxes with TurboTax or the dinkytown tax calculator https://www.dinkytown.net/java/1040-tax-calculator.html

I would suggest that you put together a plan yourself using those tools and you can ask questions here but then go over the plan with a local CPA and have them prepare your return at least for this year since you have a lot of moving parts in 2020.

 

[BizzyC]

Calmloki,

I have thought a lot about paying down the principal. Here's the whirling vortex that goes on in my head about that idea.

1. I don't feel like I can fully pay it off right now and feel comfortable w/ the liquid cash left available to cover the next 4.5 years until I can tap the 401ks/Roth.
2. Paying it partially down is indeed a guaranteed 3.5% return, but the money is then kind of locked up until I sell (yeah, maybe heloc, but that's work/hassle). If I didn't sell for 10 years, what would that money have done if it had been well invested for 10 years instead? Even in relatively safe investments, yeah, the interest rate is wretched now, but will it be over that entire 10 years? I know we each have to make our own guesses on that.

My thinking on it is that since I can't fully pay it off and buy the peace of mind that would come with that, and since I'm reasonably disciplined with investing, that I'm going to hold off on paying down prinicipal for now. I'm going to keep reviewing that decision yearly, though.

 

[BizzyC]

Oh, thank you for the very helpful reply!

Ugh, I can see that I need to go read those links and educate myself more on the tax stuff around rentals. Let me do my work before I trouble you with more questions. I'm about to run out for errands so it may be a day or two. I don't want to appear unresponsive or ungrateful for the reply, I appreciate it very much!

 

[SecondCor521]

Hi Wolf,

Yup, CA. Guess the housing prices kinda give it away. Sorry for the wordiness. My main interest is if folks think I'd be better served foregoing ACA subsidies to do more Roth conversions.

Regarding the banks preferring earned income, what you say is true, they do prefer "earned" income. And in the case of comparing potential income that may come from rental income, or may come from a job, I could certainly see why the income from a job would be more secure. My complaint is that they seem to prefer earned income from a job over cash already sitting in the bank. An employee may get fired or laid off, in which case much less money will be coming in and there may be risk that the mortgage is not paid. Why banks prefer this lending scenario over the scenario where the assets are already sitting in the bank, I cannot understand.

Generally people here seem to think that ACA subsidies are worth more than the extra Roth conversions. Even if you decided to convert more, given your age, asset level and that a bunch of your NW is tied up in your house, I can't see that you're going to ever be in the 32% bracket, and you may be able to avoid the 24% bracket as well. Therefore I don't see the sense in converting into the 24% bracket for you this year unless you're doing so as a tax-rate arbitrage play with the 2026 expiration of the current brackets and rates. But again, most people here would probably convert up to just below 400% FPL and take the nice ACA subsidy.

As far as the bank goes, you could ask about an asset depletion loan, which is designed for someone like you. Generally, the banks wonder why you would borrow money from them and pay them interest when you could just pay off your mortgage with your savings. You and I know why you might not, but they don't.

 

[OldShooter]

I am lifting an eyebrow a little at the house. First, it is a substantial fraction of your assets, which you recognize as you are looking to sell and downsize eventually. Second, the location is IMO risky as California faces financial problems and some level of exodus of higher-income earners from the state. Those are a double-whammy for the house value, higher real estate taxes and possibly fewer buyers. Rather than a refi, I would be looking to sell while the gittin's good and move to a lower tax state with lower risk of natural and climate disasters. To demonstrate a firm grasp of the obvious, if "the big one" comes your house value is toast.

 

[wolf]

I am lifting an eyebrow a little at the house. First, it is a substantial fraction of your assets, which you recognize as you are looking to sell and downsize eventually. Second, the location is IMO risky as California faces financial problems and some level of exodus of higher-income earners from the state. Those are a double-whammy for the house value, higher real estate taxes and possibly fewer buyers. Rather than a refi, I would be looking to sell while the gittin's good and move to a lower tax state with lower risk of natural and climate disasters. To demonstrate a firm grasp of the obvious, if "the big one" comes your house value is toast.

OP's house location. Prime! Even in down market, should hold most of it's value. IMHO.

 

[RunningBum]

Guess the housing prices kinda give it away. Sorry for the wordiness. My main interest is if folks think I'd be better served foregoing ACA subsidies to do more Roth conversions.

Yeah, I read this earlier and got lost in all the branches of the story. Generally I take a subsidy over more Roth conversions. You have the right idea that if you're going to go over, take advantage of it and convert LOTS. In some years you might find that the subsidy isn't that big, or some other income event will happen that's going to put you over already.

 

[OldShooter]

OP's house location. Prime! Even in down market, should hold most of it's value. IMHO.

Nevertheless, as a financial asset it's an overconcentration and risky. Houses aren't just financial assets of course, but when the house comprises as much of the OP's net worth as it does I think its necessary to look hard at that aspect.

 

[Dtail]

Another vote for the ACA subsidies over maximizing Roth conversions.

 

[BizzyC]

Hi pb4uski,

Thanks for this write up, it is really helpful to me. You're getting straight to the things I was not understanding.

Close, but not totally right.

The top of the 22% tax bracket in 2020 is $85,525 and the top of the 24% bracket is $163,300. The standard deduction is $12,400 and you can deduct $300 for contributions under the CARES Act (I assume that with your wealth you make more than $300/year in charitable contributions).

I assume that you are filing a Schedule E for the rental income and that is why you are deducting the $24,000 of house interest? Only a portion of the interest can be deducted.... but you can also deduct a portion of property taxes, insurance, etc. Also see https://www.nolo.com/legal-encyclopedia/tax-issues-when-renting-out-room-your-house.html You may also qualify for an additional 20% exclusion of your profit. So, you'll need to dive into the details on your rental activities, but for discussion purposes let's assume that it all nets down to the $12,000 that you used in your example.

No, the reason I'm deducting the house interest is because I'm a tax moron and didn't know only a portion could be deducted. I also had no idea how the rental income had to be handled, I had thought it would just be like ordinary income. The link was very helpful, I see how I'll have to do it. Ugh, so much work. Oh well, learning about taxes is the last horrible and terrifying thing I have to figure out to get control of my life. So it will be done.

So the total income that you could have at the top of the 22% tax bracket is $98,225 ($85,525 + $12,400 standard deduction + $300 contributions deduction). Subtract out $12,000 of net rental income and $18,400 of interest and that would leave room for $67,825 of Roth conversions. If you want to go to the top of the 24% tax bracket you could do as much as $145,600

Interest.................. $18,400.....$18,400
Net rental income.......12,000.......12,000
Roth conversion..........67,825.....145,600
Total income...............97,825.....176,000
Contributions deduction..(300).........(300)
Itemized deductions...(12,400)....(12,400)
Taxable income..........$85,525...$163,300

The above is based on 2020 tax brackets and standard deduction. If you're doing this figuring for 2021, the top of the 22% and 24% bracket and standard deduction are a little higher and the charitable contribution deduction might not apply. If you are going to keep your $920k invested in cash, 2% might be a bit ambitious. And of course, you need to work through the details of the rental income. Finally, you can have a plan and do a good portion of the Roth conversion early in the year (and pay the estimated tax) and then top it up with another conversion late in the year when you have better estimates of what your final tax situation will look like.

Right, I know 2% on very safe investments is not happening right now. I was using 2% as a worst case highest number to make a little buffer to avoid going over the top of the bracket.

Also a good friend for looking at various alternatives is the TurboTax What-If worksheet if you do your own taxes with TurboTax or the dinkytown tax calculator https://www.dinkytown.net/java/1040-tax-calculator.html

I would suggest that you put together a plan yourself using those tools and you can ask questions here but then go over the plan with a local CPA and have them prepare your return at least for this year since you have a lot of moving parts in 2020.

That link is also really helpful. Yeah, I clearly should work with a CPA at least this year. But I need to be sure I understand all the details and can recreate the same doing it myself, and am moving towards being able to do my own in future years. One more question, do ACA subsidies have to be reported as income? What category do those go under in the tax calculator link from above?

It makes my head hurt to think about it, but I guess I should consider doing a bigger Roth conversion (maybe up to 24% bracket) for tax year 2020 when I only had 6 months of rental income, and would only have to pay back 5 months of ACA subsidies. It's kind of a unique opportunity, next year I would expect I'm going to have 12 months of rental income and 12 months of ACA subsidies, so much less "space" to convert and stay under ACA limit.

 

[BizzyC]

Hi SecondCor521,

Generally people here seem to think that ACA subsidies are worth more than the extra Roth conversions. Even if you decided to convert more, given your age, asset level and that a bunch of your NW is tied up in your house, I can't see that you're going to ever be in the 32% bracket, and you may be able to avoid the 24% bracket as well. Therefore I don't see the sense in converting into the 24% bracket for you this year unless you're doing so as a tax-rate arbitrage play with the 2026 expiration of the current brackets and rates. But again, most people here would probably convert up to just below 400% FPL and take the nice ACA subsidy.

As I'm learning more and this is starting to gel in my head, I think what you say above is going to be right for me for 2021 tax year and going forward. A full year's worth of ACA subisidies is a good chunk of change.

As far as the bank goes, you could ask about an asset depletion loan, which is designed for someone like you. Generally, the banks wonder why you would borrow money from them and pay them interest when you could just pay off your mortgage with your savings. You and I know why you might not, but they don't.

It's just frustrating to me to not be able to refi and get a lower mortgage rate given the amount of equity I already have, my credit history, assets, etc.

 

[BizzyC]

Hi OldShooter,

I am lifting an eyebrow a little at the house. First, it is a substantial fraction of your assets, which you recognize as you are looking to sell and downsize eventually.

Yes, you are right. It is just a fact. I didn't really plan it out this way or target to get to this place, but with an unexpected divorce late in life, this is the hand I have to play.

Second, the location is IMO risky as California faces financial problems and some level of exodus of higher-income earners from the state. Those are a double-whammy for the house value, higher real estate taxes and possibly fewer buyers. Rather than a refi, I would be looking to sell while the gittin's good and move to a lower tax state with lower risk of natural and climate disasters. To demonstrate a firm grasp of the obvious, if "the big one" comes your house value is toast.

Yeah. The concerns you raise are real, and I have had a lot of those same thoughts myself. I'm not discounting what you say at all. But for the short term at least, I'm staying put. There are some non-financial reasons for that, friends, weather, recreational opportunities, etc, even just needing to have a little stability after sooooooooooooo much turmoil in my life over the last ~4 yrs. But I do feel like longer term after the dust settles a bit, it will remain at least a stable investment. I don't see prices going down a huge amount. Sure, there are some things that can be done over Zoom, but in my opinion, there's still a lot that can only be done in person. I think right now people are overestimating how successful remote work can be. Some jobs, sure, no problem. Training new engineers? No. Negotiating tricky deals? No. Establishing new business relationships? No. There's just a lot of synergy to all of the high tech going on here.

About property taxes, yes, they are horrible, but at least we have prop 13 limiting the rate of increase so at least they are a known quantity. Regarding natural disasters, yeah, it's possible. I have earthquake insurance but it would be a big financial blow if it happened. Yet another thing to think about these days is climate change and how that may affect future values.

Anyway, you are correct to point out that it is a risk. For the short term, I am choosing to accept the risk. If it all goes south I promise not to say you didn't warn me.

 

[OldShooter]

... For the short term, I am choosing to accept the risk. ...

No harm, no foul. It's your hand to play and you get to decide how play it. I understand completely about the non-financial factors.

The only reason I brought it up, as I sad, is that it is such a big factor in your assets. So it's worth a hard look, which you have done.

 

[BizzyC]

Hi RunningBum,

Yeah, I read this earlier and got lost in all the branches of the story. Generally I take a subsidy over more Roth conversions. You have the right idea that if you're going to go over, take advantage of it and convert LOTS. In some years you might find that the subsidy isn't that big, or some other income event will happen that's going to put you over already.

I'm starting to think the same thing. My tax year 2020 might be a good time for me to pay back the ACA subsidies and do a fat conversion, then next year settle back down and manage for ACA subsidies. Yikes, running out of time to figure it out and get it done.

 

[BizzyC]

No harm, no foul. It's your hand to play and you get to decide how play it. I understand completely about the non-financial factors.

The only reason I brought it up, as I sad, is that it is such a big factor in your assets. So it's worth a hard look, which you have done.

You gave me appropriate and thoughtful advice, I am nothing but appreciative!

 

[Time2]

Hi RunningBum,




I'm starting to think the same thing. My tax year 2020 might be a good time for me to pay back the ACA subsidies and do a fat conversion, then next year settle back down and manage for ACA subsidies. Yikes, running out of time to figure it out and get it done.

Don't forget you can do Roth Conversions for the next 17 years, before RMDs are required. They may even chnge that 20 years, (75yrs old).

 

[BizzyC]

Don't forget you can do Roth Conversions for the next 17 years, before RMDs are required. They may even chnge that 20 years, (75yrs old).

Right, that's a good point.

 

[SecondCor521]

One more question, do ACA subsidies have to be reported as income? What category do those go under in the tax calculator link from above?

ACA subsidies are a refundable tax credit and are therefore not reported as income. On the Dinkytown calculator that pb4uski linked to, it's listed in the "Total payments & refundable credits" section and is called the "Net premium credit (Form 8962)" there.

If you received the advanced premium tax credit (APTC), also known as a subsidy, and are therefore paying less than the full premium, then you would reconcile what you received with what you should have received on Form 8962. If you didn't get enough and should have gotten more, then you'll get an additional credit for the difference (which is what Dinkytown is expecting you to put on that line in their calculator). If you got too much, then you'll end up paying some or all of it back.

 

[CSdot]

Hi all,

I own a house. Zillow thinks the house is worth $3.1M. I owe $662k on the mortgage. My mortgage rate is 3.5%. I have a renter who pays me $2800/mo.

Saw this, read it to my wife and she said "must be California."

Anyway, don't have anything useful to add, but was wondering if the "renter who pays [you] $2800/mo. is:

(a) a roommate;
(b) someone who rents your guesthouse (I envision a Magnum PI type tenant, with you being Robbin Masters); or
(c) if $2800/mo. is what a $3.1M house rents for in your part of California?

My non-serious just being silly answer to your fact pattern is to suggest you sell the house and take the $2.4M worth of equity and move to anywhere else USA and live like royalty.

Just playing. Enjoyed the read. Hope you get some useful responses from the other members here.

 

[foxfirev5]

Saw this, read it to my wife and she said "must be California."

Anyway, don't have anything useful to add, but was wondering if the "renter who pays [you] $2800/mo. is:

(a) a roommate;
(b) someone who rents your guesthouse (I envision a Magnum PI type tenant, with you being Robbin Masters); or
(c) if $2800/mo. is what a $3.1M house rents for in your part of California?

My non-serious just being silly answer to your fact pattern is to suggest you sell the house and take the $2.4M worth of equity and move to anywhere else USA and live like royalty.

Just playing. Enjoyed the read. Hope you get some useful responses from the other members here.

No need to be humble. Your answer is probably the most succinct in this this thread.