Background: A client had a large retirement account with $1,000,000 of value (100% in a deferred tax IRA) and this is the only asset that he owns that could be used to produce income. All of the retirement account is held in a 6% income based variable annuity. Client is deferring his Social Security payments to age 70 and he is now 66.
Our Case: The client’s Social Security is expected to be in the $60,000 range when he starts drawing at age 70 and his IRA is expected to produce a level $60,000 in income that the 6% variable annuity would produce. Because the IRA will produce income exceeding $35,000 per year, 85% of the client’s Social Security will be subject to income taxation.
The Question: Would it make sense to convert the IRA to a Roth IRA, even if it meant creating a mortgage or loan that would have to be paid back in the future? Based on an effective tax rate of 20%, his current situation causes 85% of $60,000 or about $50,000 to owe income taxes of approximately $10,000. In other words his total taxable income of $60,000 + $50,000 (+ $10,000 of non-taxed Social Security) creates total taxes of 20% or $22,000. Thus, after-tax income of $120,000 – $22,000 = $98,000. If we convert, the “one-time” tax bill would be in the $300,000 range; but all future income would be 100% tax free, as the Roth would still produce $60,000 and Social Security would still produce $60,000, but zero tax would be due. The payment on a $300,000 mortgage would be around $20,000 a year (3.25% – 15-year mortgage), so the client would have $120,000 of income minus a mortgage for 15 years = $100,000 of income ($2,000 increase for the next 15 years and a $20,000 increase thereafter).
The Results: The client really liked the analysis and gained understanding on how to eliminate taxes on Social Security income, but when the thought of actually paying $300,000 in one year to the Government became a requirement, client decided not to proceed. 15 years from now we will determine if this was the right or wrong decision.
Bottom Line: All decisions in life are not financial and the mere thought of debt might not make this idea viable for this or any client. Risk of Social Security or the insurance company not continuing the $60,000 payments certainly exists while a debt of $300,000 does not disappear until paid in full.
This is a hypothetical example for illustrative purposes only. The experience of this client may not be representative of the experience of all clients and is not indicative of future results. Any tax advice contained herein is of a general nature and is not intended for public dissemination. Further, you should seek specific tax advice from your tax professional before pursuing any idea contemplated herein. This advice is being provided solely as an incidental service to our business as financial planner. Securities offered through ValMark Securities, Inc. Member FINRA, SIPC. Financial Planning and Investment Advisory Services offered through B & E Investment Advisers, Inc. Business & Estate Advisers, Inc. and B & E Investment Advisers, Inc. are separate entities from ValMark Securities.