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Hi everyone,

Long rambly post (I first tried this one on the LBYM board where I tend to hang out and was referred here) --

I am 32; DH is nearly 50. This year, our AGI is under the limit for being able to convert a traditional IRA to a Roth. Next year, and for the foreseeable future, it won't be.

We have 2 kids (my stepkids) in college. We and their mother pay their way, beyond whatever aid they qualify for, which is mostly unsubsidized loans. This year, one kid qualifies for the Hope Credit and the other for Lifetime learning. We have to claim them to get these; their mom files married-filing-separately.

I have a trad IRA worth about $8k. I am wanting to convert it. The net cost of doing this is almost $3k -- $2.3 in taxes (28% bracket), $460 in lost educational credits, plus -- here's where things get still more dicey -- in order to do the conversion and my regular Y2K Roth contribution (that I haven't done yet...) I need to borrow $2k from my 403b account at 7.9%. I do understand that I am borrowing pre-tax money, paying it back with post-tax.

I'm basically inclined to proceed with this in spite of the cost. I figure borrowing against the 403b as a low-risk strategy because I could always yank the principal (i.e. Y2K contribution) back out of the Roth -- I will keep it "in the bank," rather than stocks, 'til the loan is paid off -- to pay off the loan. Also, I expect to be able to pay that loan off very quickly (see below).

An important point here is that we LBOM...not as much as we should, perhaps, but our net worth is increasing, not decreasing. We do have some consumer debt...a car loan about $9k at 6.25% (I had just started paying extra on this, but now have temporarily quit due to the Roth issues, but will start again ASAP). Also, I fully fund my 403b, and DH is in a defined-benefit pension plan and also contributes about 2/3 of his allowable extra amount to a 403b (yes, that needs to go up to 100%...). Also, I have taken on some extra projects at work that will result in my net pay over the summer months being about double what it usually is, for 3 months (total take-home bonus=about $7k)...but I cannot have that money until June/July/August. This is why the 403b loan should be a very short-term thing.

DH, himself somewhat of a "grasshopper" rather than an "ant" (as I tend to be) is worried about what this is costing us...it is a lot, even more than converting this amount "should" cost because of the lost educational credits and the interest charges. But I see it as good long-term planning...not just for retirement but potentially as estate planning. I fear if we wait
'til our income again drops below the allowable AGI to convert, the value of the IRA will be much larger and thus, conversion will be even more costly. But he makes the point that by the time I am 59&1/2 he will be 75 or so and that he won't ever "benefit" from this investment...

I should perhaps mention that investing the capital that we will otherwise pay to cover the costs of the conversion in a separate account is out of the question...I will be able to persuade DH that we have to pay the feds but not that we must set that money aside elsewhere...this is not rational, perhaps, but it is true...

Thoughts? Thanks in advance,
HB
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You also forgot to take into account the "penalty" on the 403b. When you take the loan and pay it back, you are using after-tax dollars to put the money back in. Once you retire and withdraw this money, you will once again pay taxes on the money you put back in. So you are going to be paying taxes twice on monies used to convert the IRA. This is something that many people fail to realize before they take loans out on their 401(k). Not to mention the lost opportunity the loan money is missing out on by not being invested.

You said that you could fall back on getting the principal out of your Roth IRA. This is true only after the money has been in the Roth for 5 years. Before 5 years, you will pay a penalty if you withdraw the principal.

IMHO I don't think the cost of converting the IRA at this point is worth it. But this is a decision you have to make. You may want to re-run all your numbers and see if it will be a good fiscal descision. Perhaps you could convert a portion this year and a portion next year. This way you could spread out the tax burden over a period that you may be able to pay with non borrowed money.
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You also forgot to take into account the "penalty" on the 403b. When you take the loan and pay it back, you are using after-tax dollars to put the money back in. Once you retire and withdraw this money, you will once again pay taxes on the money you put back in. So you are going to be paying taxes twice on monies used to convert the IRA.

It's not double taxation. You do NOT pay income tax when you borrow pre-tax money from a tax deferred account. Your loan payments are not contributions, you are simply replacing these not-yet-taxed dollars. When you retire, you must then pay taxes on these dollars when you make withdrawals, but these dollars, and their earnings will be taxed only once.
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OK, wait, I seem not to have made myself clear...

There are 2 (potential) Roths here.
A converted Roth that I could still recharacterize before 4/15. Leaving this 8.2 account converted is going to cost me about 2.8k in taxes (28% plus lost educational credits.

A contributory Roth that already exists but to which I have not made my Y2K contribution. To make the contribution by 4/15 (actually 4/16 this year...) and come up with the $$$ to pay the tax on the conversion, I would have to take a $2k loan against my 403b. I could then always yank the $$$ back out of the contributory Roth to pay off the loan -- though this would be silly, it is possible, if, for example, an unanticipated medical emergency prevented me from completing the extra projects I am taking on at work that will increase my salary this summer (see original post).

I do understand that the money I pay back to the 403b is taxed.

I also understand that I cannot access the funds in the converted Roth for 5 years.

I cannot convert part of the Roth next year or for the foreseeable future, because our AGI appears likely to exceed the $100k limit for conversions.

Anyway, more thoughts appreciated...
HB
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PMcMullenCT, you are wrong. The loan repayment is with after-tax dollars. This means that your are taxed while repaying. This repayment money is not kept seperate so you are taxed once it is pulled out at retirement.

Many people don't think about this double taxation when thinking about taking the loan.
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PMcMullenCT writes:

You also forgot to take into account the "penalty" on the 403b. When you take the loan and pay it back, you are using after-tax dollars to put the money back in. Once you retire and withdraw this money, you will once again pay taxes on the money you put back in. So you are going to be paying taxes twice on monies used to convert the IRA.

It's not double taxation. You do NOT pay income tax when you borrow pre-tax money from a tax deferred account. Your loan payments are not contributions, you are simply replacing these not-yet-taxed dollars. When you retire, you must then pay taxes on these dollars when you make withdrawals, but these dollars, and their earnings will be taxed only once.

It all depends on how you look at it. And the way I view it, your answer is totally incorrect.

The "interest" you pay yourself on the loan is paid with after-tax or already taxed dollars. That "interest" is considered earnings in the plan. When withdrawals start, that "interest" will be taxed again. And that's simply another reason not to borrow from 401k or 403b or 457 or any other type of deferred compensation plan.

Regards..Pixy
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PMcMullenCT, you are wrong. The loan repayment is with after-tax dollars. This means that your are taxed while repaying. This repayment money is not kept seperate so you are taxed once it is pulled out at retirement.

Then by that logic you are ignoring the income that NEVER gets taxed AT ALL. The pre-tax money that went into the 401K was taken out as loan proceeds without being taxed. By claiming that the loan repayments are double taxed, you are ignoring the fact that those loan payments are simply replacing pre-tax money in the 401K, which by your logic, were disbursed tax free rather than removed temporarily, and later replaced.

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It all depends on how you look at it. And the way I view it, your answer is totally incorrect.

The "interest" you pay yourself on the loan is paid with after-tax or already taxed dollars. That "interest" is considered earnings in the plan. When withdrawals start, that "interest" will be taxed again.

That's true, in a way, but suppose you took out a loan from Citibank instead. You'd pay your own tax on income, then the interest payments to Citibank would be taxable as income for Citibank. For that matter, every dollar you spend is double taxed - taxed as your income when earned by you, and then taxed again when it generates profit for a business when you purchase goods or services. The same thing happens with your 401K, as the loan generates income for your retirement account, much the same as if it were invested in stocks or bonds.

It seemed it was being claimed that the entire loan payment was being double taxed. Perhaps I misunderstood.
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PMcMullenCT writes:

You'd pay your own tax on income, then the interest payments to Citibank would be taxable as income for Citibank. For that matter, every dollar you spend is double taxed - taxed as your income when earned by you, and then taxed again when it generates profit for a business when you purchase goods or services. The same thing happens with your 401K, as the loan generates income for your retirement account, much the same as if it were invested in stocks or bonds.

Hmmm... My guess is with that convoluted logic you must be a government economist looking at the macro picture. :-)

Personally, I think your position is balderdash. I, as an individual, won't get taxed again on interest paid to a bank. In fact, depending on the type of credit used, I might even get a tax deduction. To me, that's not "double taxation," but a tax break. Further, the fact that the "interest" I pay into a tax deferred account (with already taxed dollars mind you) will get taxed again when withdrawn is a loss -- not a gain -- to me, personally. That money is really not income to me. It's forced savings out of current net earnings to replace money that MIGHT have been earned because I was an idiot and borrowed from my deferred retirement plan. Therefore, it's fine or penalty for the loan, not income, but it will be taxed as such later. Thus, from a personal viewpoint, I might win in the first instance, but I definitely lose in the second.

The economist might be concerned about "double taxation" when the banker gets taxed on income that business earns. I am not because that's how the economy works. I only care when I get taxed again on any of my money that's already been taxed. That, at least in my mind, is the only "double taxation" that really matters.

Regards..Pixy
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The economist might be concerned about "double taxation" when the banker gets taxed on income that business earns. I am not because that's how the economy works. I only care when I get taxed again on any of my money that's already been taxed. That, at least in my mind, is the only "double taxation" that really matters.

Consider that the pretax money in one's 401K will be invested in some investment, and any gains on those investments will be taxable when withdrawn during retirement. If the investment is in stocks, that growth will be taxed and any earnings from bonds will be taxed. Similiarly, if the "investment" is a loan to yourself, the earnings on that investment will be taxed.

If you object to the double taxation of your loan interest, consider that there's really no avoiding the tax, unless you use a tax favored loan such as a home equity loan. If you had instead borrowed from Citibank, you would repay them with after tax money, and your 401K funds would be invested elsewhere, would presumably earn gains, which would be taxed. You'll still pay a tax on gains, the only difference is whether those gains occurred though market investments, or from a loan to yourself.

I agree that one shouldn't make a practice of borrowing from a 401K plan, if you must borrow from somewhere, it might in some circumstances be advantageous to use your 401K funds. If the only alternative is a 15% personal loan from a bank, a 401K loan would probably be a better option.
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skinnyfong: "PMcMullenCT, you are wrong. The loan repayment is with after-tax dollars. This means that your are taxed while repaying. This repayment money is not kept seperate so you are taxed once it is pulled out at retirement.

Many people don't think about this double taxation when thinking about taking the loan."


I agree that skinnyfong is describing the situation correctly, but I think it irrelevant. All personal loans are paid back with after-tax income. All dollars withdrawn from the retirement account are taxable upon withdrawal. These dollars are no different.

The bigger issue is the opportunity cost issue raised in the prior post and, in all likelihood, the risk of a deemed distribution if job is lost for any reason. As hbogart points out, the $2000 Roth contribution can be withdrawn at any time if this becomes an issue.

Regards, JAFO
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TMFPixy: "The "interest" you pay yourself on the loan is paid with after-tax or already taxed dollars. That "interest" is considered earnings in the plan. When withdrawals start, that "interest" will be taxed again. And that's simply another reason not to borrow from 401k or 403b or 457 or any other type of deferred compensation plan."

As I said in my other post, I think it irrelevant, and I have danced this dance with Pixy before. Enough said.

Regards, JAFO

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TMFPixy: "Personally, I think your position is balderdash. I, as an individual, won't get taxed again on interest paid to a bank. In fact, depending on the type of credit used, I might even get a tax deduction. [JAFO - not for personal loan] To me, that's not "double taxation," but a tax break. Further, the fact that the "interest" I pay into a tax deferred account (with already taxed dollars mind you) will get taxed again when withdrawn is a loss -- not a gain -- to me, personally. That money is really not income to me. It's forced savings out of current net earnings to replace money that MIGHT have been earned because I was an idiot and borrowed from my deferred retirement plan. Therefore, it's fine or penalty for the loan, not income, but it will be taxed as such later. Thus, from a personal viewpoint, I might win in the first instance, but I definitely lose in the second."

I spoke too soon. I still think the argument irrelevant. Let's compare two scenarios.

Individual 1 borrows from retirement plan, at 8%, and repays --- using after-tax dollars. When those dollars are withdrawn, the the withdrawal is subject to income tax.

Individual 2 (twin brother to individual 1) borrows from a bank, unsecured, personal loan in same amount as indiviudal 1. Dollars left in the plan that were not borrowed are invested in corporate bond paying 8%. When bank loan is repaid, after-tax dollars are again used to make the payment. When the dollars are withdrawn from the retirement plan, those dollars are taxable.

If Individuals 1 and 2 borrow on the same day, repay on the same schedule, and withdraw on the same dates, there is no difference between the two situations. To make differences exist between the two loan scenarios, either the interest on the personal loan needs to be deductible OR you have to assume a better rate of return on the assets left in the plan (the "opportunity cost" issue). The only other potential risk is whether the loan from retirement plan might be callable upon loss of job, leading to a deem distributionis not repaid.

Regards, JAFO
(who continues to think that this particular double taxation argument is much ado about nothing)


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JAFO writes:

Individual 1 borrows from retirement plan, at 8%, and repays --- using after-tax dollars. When those dollars are withdrawn, the the withdrawal is subject to income tax.

Individual 2 (twin brother to individual 1) borrows from a bank, unsecured, personal loan in same amount as indiviudal 1. Dollars left in the plan that were not borrowed are invested in corporate bond paying 8%. When bank loan is repaid, after-tax dollars are again used to make the payment. When the dollars are withdrawn from the retirement plan, those dollars are taxable.


Individual 2 is NOT borrowing HIS OWN money and is NOT paying himself interest, whereas Individual 1 is. Therefore, IMHO it is complete lunacy to attempt to claim there is no double taxation issue here. However, I can see we will never agree on that issue, so I also concur that the argument is much ado about nothing. The idiot shouldn't borrow from a tax deferred plan to begin with. :-)

And FWIW I think your or my memory is failing for I recall no such conversation or debate with you before on this issue. Not that it would have gone any differently, though. :-)

Regards..Pixy

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HB,

A car loan at 6.25% is a reasonable interest rate, possibly less than what could earn in stocks. I don't see any benefit in getting that paid off early except the good feeling of having less debt.

[You're losing the educational credits because of phase-out -- the IRA conversion results in a surge of income for the year?]
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TMFPixy:

JAFO writes:

<<<<Individual 1 borrows from retirement plan, at 8%, and repays --- using after-tax dollars. When those dollars are withdrawn, the the withdrawal is subject to income tax.

Individual 2 (twin brother to individual 1) borrows from a bank, unsecured, personal loan in same amount as indiviudal 1. Dollars left in the plan that were not borrowed are invested in corporate bond paying 8%. When bank loan is repaid, after-tax dollars are again used to make the payment. When the dollars are withdrawn from the retirement plan, those dollars are taxable.>>>>

"Individual 2 is NOT borrowing HIS OWN money and is NOT paying himself interest, whereas Individual 1 is."

Agreed.

"Therefore, IMHO it is complete lunacy to attempt to claim there is no double taxation issue here."

I did not claim that there was no double taxation, I said it was irrelevant. Dollars are fungible; if you look at my two indiviudals (and further assuming that each is in the same tax bracket at all times), there is no difference between cash flow or total taxes paid by either indiviudal - that is why I consider it irrelevant. The net after-tax dollars available to each is the same --- why would either care which scenario gnerated it.

As I acknowledged before, if you make the loan interest for indiviudal 2 deductible - home equity, margin, etc. or you change the investmetn result for individual 2 (Opportunity cost), you can vary the result --- but the result is varying for some reason other than the double taxation.

"However, I can see we will never agree on that issue, so I also concur that the argument is much ado about nothing."

Probably, but I can always hope.

"The idiot shouldn't borrow from a tax deferred plan to begin with. :-)"

As a general rule, I agree. I just do not think that the rule is absolute. <grin>

"And FWIW I think your or my memory is failing for I recall no such conversation or debate with you before on this issue. Not that it would have gone any differently, though. :-)"

It could be my memory, or maybe it was TMFTaxes and not you. As best as I can recall, I have had this discussion with one of the pro TMFs.

Regards, JAFO


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JAFO writes:

I did not claim that there was no double taxation, I said it was irrelevant. Dollars are fungible; if you look at my two indiviudals (and further assuming that each is in the same tax bracket at all times), there is no difference between cash flow or total taxes paid by either indiviudal - that is why I consider it irrelevant. The net after-tax dollars available to each is the same --- why would either care which scenario gnerated it.

As I acknowledged before, if you make the loan interest for indiviudal 2 deductible - home equity, margin, etc. or you change the investmetn result for individual 2 (Opportunity cost), you can vary the result --- but the result is varying for some reason other than the double taxation.


I can agree to the irrelevancy part. My mistake. I thought you were insisting there was no double taxation. Without running the numbers, I'll accept at face value your claim on net dollars being the same between your two scenarios. It looks correct on the surface, and I'm too lazy. :-)

Regards..Pixy

Regards..Pixy
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