Question From A Reader â€“ Refinance A Home To Pay Taxes For A Roth IRA Conversion?

By Hank on 09/03/2010 – 3:48 am PST -- Opinion

I recently received a question from a reader. If you have a question, be sure to contact me.

A reader recently asked, “Do you think refinancing a home loan and using some equity to convert a 401k to a Roth IRA is a good idea?”

More Debt Always Sounds Like A Bad Idea

There are a lot of different variables involved, and you only told me a little bit of the back story. But….No, I don’t think it is a good idea. How long are you going to stay in your home? You are going to cash out some or all of your equity and pay taxes with it. You might not be able to cover your new mortgage if you wanted to or needed to sell your home very soon. It would depend on how much equity you have left in the house. Dave Ramsey always says that 100% of the homes in America that were foreclosed on had a mortgage on them. So, if your house was completely paid for, I would hate for you to go back into debt just to pay taxes to the government on a Roth conversion.

The Best Way To Pay Your Taxes

The best way to pay for the taxes when doing a Roth IRA conversion is using money from non-retirement investment accounts (stocks, mutual funds, or bonds) or in savings, money markets, or CD type of accounts. If you used proceeds from your retirement account and are not 59 Â½ years old, you will have to pay taxes right away and a 10% early withdraw penalty.

What If You Cannot Pay Your Taxes

If you don’t have the money to pay the taxes just sitting idle right now, you might want to consider just diverting future money from your 401k to a Roth instead. Not the best solution, but it will get you investing in a Roth and not in your 401k if you aren’t investing in a Roth already. I don’t know your specifics but if you are choosing just one or the other, usually a Roth IRA instead of a 401k is better for individuals if they think taxes are going up in the future.

Roth IRA conversions are a great option for people this year, but only if you can afford the taxes. And, remember, the best place to find that money for your tax bill is accounts that are not earmarked for your retirement. And, of course, be careful when using your home equity for anything especially paying your taxes.

Iâ€™m always looking for new questions and will always spend you a reply back even if I donâ€™t use you question here on the blog

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Muneer

If you refinance your home and get a lower mortgage rate while you save money on your mortgage payments, and with the saved money you pay your roth conversion taxes, that’s a good idea. But here’s an important point

Let’s clarify this. While you would do a conversion from a traditional IRA or other plan in to a Roth IRA in 2010, the capital gains or income to be claimed on your taxes will not be done until 2011 and 2012, thus saving you from facing a huge tax bill in 2010. The IRS is aware of this and they have allowed you to claim 50% of your capital gains income in 2011, and the remaining 50% in 2012, thus splitting the bill across 2 years.

Note: You would pay taxes in 2011 and 2012 according to the tax bracket you’re in. For instance, if you made a lot more money in 2012 than 2011, you would pay more of the conversion taxes in 2012 rather than 2011. However, your total conversion tax will be prorated across the 2 years.