This is a math equation that I don’t have all the variables to, plus there are other non-quantitative factors too. But I'll lay out some of the math and what else you should consider.
First off, you're obviously thinking about retirement and whether it makes sense to pay taxes on your pre-tax retirement savings now (converting to Roth) versus in retirement. I'll assume you're under 59 1/2. If you’re under 59 ½ and pay the taxes using the assets converted to a Roth, you will pay a 10% penalty on the tax amount. The best scenario when converting IRA assets to a Roth is having free cash outside of the IRA to pay the taxes.
- you're under 59 1/2
- you're in the 28% tax bracket
- you don't have free cash to pay the taxes so you need to pay the taxes from the IRA conversion or from another source (like the loan you're considering).
Let’s say you convert the $400,000 IRA. You'd have a $112,000 tax bill. If you pay the taxes from the converted amount, add another $11,200 in penalties (if you're over 59 1/2 then this wouldn't apply), resulting in a net amount invested into the Roth of $276,800. If the account earns 6% a year, it will hold $495,700 ten years down the road and any distributions will be totally tax free. If you don’t convert to a Roth, your $400,000 would grow to $716,339. But if you’re still in the 28% bracket, 28% of the money is Uncle Sam’s. Peel off his share and you have $515,765 after taxes. (This example ignores state income taxes). If you didn't have to pay the 10% penalty, your Roth would have $515,765 after 10 years, the same amount as the after tax IRA. So, if you don't have to pay the penalty, you can still take the monies from your Roth and come out in the same position. If your anticipated tax rate in retirement will be higher than it is now (no one really knows, and the younger you are the harder it will be to predict rates in the distant future), converting to the Roth now and paying taxes from the proceeds without the penalty is the most beneficial situation. A lower tax rate now with a higher tax rate in retirement gives the advantage to converting to a Roth. When you have a lower tax rate in retirement, a traditional IRA will net you more. Here’s a calculator to test different assumptions and tax rates: http://www.bankrate.com/calculators/retirement/convert-ira-roth-calculator.aspx
Now let's layer in the situation where you take a loan. The type of loan is certainly a factor. If the loan has interest that you can deduct on your taxes resulting in a lower net cost (like a home equity loan), then that's better than a personal loan where the interest doesn't benefit you. Let's assume the interest isn't deductible. The benefits you get with paying the taxes with a loan is that all of the IRA monies go into the Roth and the full amount is tax free in retirement. It’s the impact from the loan that can have a negative downstream effect that you need to account for.
If you took a 5 year loan at a rate of 8.5% on $112,000, you'd pay about $2,300 per month, and total interest over the term of the loan totaling about $26,000. If you were able to get a rate of 4% you’d pay about $13,000 in interest. Compare the interest numbers to the penalty you’d pay if you paid the taxes out of the IRA ($11,200). On a net basis, you’re better off paying the 10% penalty. If you’re thinking that keeping the $400,000 in the Roth is preferable so that those monies can grow tax-free, you’re right, it is preferable. $400,000 after 10 years at 6% is $716,325. The loan for the taxes with interest would have cost you $138,000. The difference is $578,325. That’s the highest net number of all the scenarios, however the downstream issues could be significant depending on your situation. You’ll have monthly payments you need to make for 5 years. What will $2,000+ per month do to your budget? Will those payments impact the amount you can contribute to a 401k for the duration of the loan? If that’s the case, will you miss a matching contribution from your employer, thereby leaving money on the table? What will the impact to your cash flow do to other goals?
In addition, when you convert the IRA to a Roth, the whole amount counts as income. A significant increase in your income could impact tax credits or other income based calculations, such as getting needs based financial aid for a child headed to college. You definitely should consider your income bracket and try to avoid pushing it higher by converting too much to the Roth. You can convert just portions of the IRA in order to manage your taxable income and possibly spread out the impact in order to avoid taking a loan.
There are a lot of variables here that you need to look at before taking next steps. I’d recommend having a Certified Financial Planner look at your question in conjunction with your entire situation to help you determine the best next steps.
WalletHub Answers is a free service that helps consumers access financial information. Information on WalletHub Answers is provided “as is” and should not be considered financial, legal or investment advice. WalletHub is not a financial advisor, law firm, “lawyer referral service,” or a substitute for a financial advisor, attorney, or law firm. You may want to hire a professional before making any decision. WalletHub does not endorse any particular contributors and cannot guarantee the quality or reliability of any information posted. The helpfulness of a financial advisor's answer is not indicative of future advisor performance.