Tuesday, March 20, 2012

Should You Pay the Taxes and Liquidate Your IRA?

As I describe in my book, Keep Your Assets. Take My Advice. It is Easier to Climb Out of a Shallow Hole, there is a way to pay the taxes on an IRA at a lower cost when used in conjunction with a Home Equity Line of Credit or an existing Life Insurance Policy with enough cash values. You are probably thinking...Huh?

Here is how it works:

I like to keep it simple, or as the late, great Steve Jobs said:

Simplicity is the ultimate sophistication.

Suppose we have a $100,000 IRA. If we either convert it to a Roth IRA or just plain cashed it in, then we would likely owe taxes of $25,000 or more. However, let's keep it simple and assume $25,000 is our tax bill for this transaction.

What are some of the ways that we could pay this $25,000 tax bill?

  1. We could pull the $100,000 out of the IRA and just put it in a bank account and write a check from the proceeds for $25,000. This would net us $75,000 and our cost would be a simple 25%. You're not fired up about this idea, are you? Neither am I.
  2. Or, we could convert the $100,000 IRA to a Roth IRA and pay the taxes from the Roth IRA. You can always pull your cost basis out of a Roth IRA. Since, we just put $100,000 into it, we can pull out $25,000 as part of our cost basis contribution and pay the taxes. However, we would be in the same boat as number one above. We would owe $25,000 or 25% in taxes. Okay, Rick...when are you going to get to the point?
  3. Instead of numbers one or two above, we could take advantage of a Home Equity Line of Credit and leverage these funds to pay our taxes at a lower rate. You borrow the $25,000 to pay the taxes at an Interest Only Rate of say 4%. The $100,000 that you pulled out of your IRA is either now in an Investment Account or a Roth IRA. Either way, it grows for the next 5 years at a rate of at least 4.564%. At the end of 5 years, the $100,000 has grown into $125,000. (My trusty HP12c Platinum Calculator says so!) We take a withdrawal of $25,000 and pay off the Interest Only Loan. What did it cost us to do this?
    1. It cost us 4% interest on $25,000 spread out over 5 years, or a total of $5,000. So, to get our $100,000 IRA out of IRA status and either turn it into an investment or a Roth IRA, we paid 5% total on the $100,000 IRA withdrawal. Is 5% spread out over 5 years better than $25,000 or 25%? You bet it is.
    2. How easy would the decision to cash in your IRA be if you knew you could do it at 5%?
  4. Another alternative is if you have an existing Life Insurance Contract with loanable values of more than $25,000. Most Whole Life and Universal Life policies allow you to borrow money from the policies at either a net 2% or even a net 0% rate. So, what you do is borrow the $25,000 to pay the taxes from the Life Insurance policy. Pay an interest only amount back into the policy for 5 years, like $1,000 a year. (Okay. I know what you are thinking. Why don't I just pay it at the 2% rate or $500? Because you are cheating yourself. That's why.) Then, at the end of 5 years, after your formerly $100,000 IRA has grown either as an investment or as a Roth IRA, then you take a withdrawal and pay back your Life Insurance Policy. The difference using this approach is that instead of the bank keeping the $1,000 in interest, you have paid it into the Life Insurance policy and depending on the policy you have, you may have actually paid yourself interest.
    1. Wait a minute. If you paid yourself back the $1,000 a year for 5 years and you had a zero net cost loan rate on your Life Insurance policy, then what did that cost you? Now you are thinking! Instead of costing you 5% to cash in the $100,000 IRA, it cost you 0%!!
    2. The truth is that there is some minute costs related to how much your insurance policy is crediting your $1,000 that you are paying back in interest, but it is still a great way to leverage money that you already have to make your IRA into a Non-IRA or better yet, a Roth IRA that grows tax-deferred with tax free withdrawals.
There are some life insurance policies that are structured to do this exact scenario, but I cannot tell you unless you come see me. Their lawyers would kill me if I named the companies without their legal approval. Keep in mind that it may be easier to do this with a Home Equity Line of Credit, because not everyone has over $25,000 laying around inside the cash values of their Life Insurance policies.

Of course, each strategy described here should not be done on your own without fully understanding the entire consequences. Further, I would be able to show you the real numbers and how this all works being the Certified Financial Planner® extraordinaire that I am.

The thing to realize is that any money in an IRA account is taxable when it comes out. If you let your IRA continue to grow, then your tax liability also continues to compound. So, the sooner you can eliminate your IRA by paying the taxes with leveraged money, then the better off you will be.

These strategies take careful planning and analysis and should not be done on your own. If you need help, or want to see how this would work in your situation, then give me a call at 904-547-2913.

Later my friends.