One of the most common questions among younger high-income families is whether they are saving money into the right type of accounts. Many come in with an emergency fund in place, maxing out their 401(k)s and even making 529 contributions. “So, what else should I be doing?” Most people know that in the retirement savings world, Roth assets are as good as it gets. The difference between tax-free and tax-deferred could be significant over time, so it is logical that we facilitate this process for many folks year after year.
You may be familiar with the difference between Roth savings and pretax (traditional) retirement savings accounts, but if not, here are the basics. A Roth contribution can be deducted from ordinary income the year it is made. It accumulates and distributes tax-free. A pre-tax or Traditional retirement contribution typically can be deducted from ordinary income the year it is made. It accumulates tax-deferred, meaning you don’t need to worry about dividends or capital gains along the way, but 100% of distributions are taxable as ordinary income.
The benefits of having Roth money are obvious, but there is a problem. Income limitations dictate that an individual earning $139,000 or a married couple filing jointly earning $206,000 is ineligible to contribute to a Roth IRA1. As the tax code currently stands, there is a way around that. The solution is known as the “backdoor” Roth IRA. Here are the mechanics of how it works:
- The individual makes a non-deductible contribution to a Traditional IRA, which has no income limitations.
- The IRA can then be converted to Roth. Roth conversions also have no income limitations.
- Since the IRA contribution was not deducted, the basis equals contribution. There is no tax liability on the conversion.
Consider the long-term impact for a high-earning couple. Let’s assume they each fund backdoor Roth IRAs from ages 30-59, they earn a 7% rate of return, the max contribution stays at $6,000 per person per year and they don’t participate in catch-up contributions. This couple will start their retirement at age 60 with more than $1.1 million in Roth IRAs. They can continue to watch it grow tax-free or start taking distributions any time after age 59 ½. Income produced by the distributions won’t impact their taxes. Since they will be drawing tax-free income from these accounts, it could keep them in a lower bracket overall in retirement. For many, this strategy can be a game changer.
The biggest pitfall you need to be aware of is that the IRS does not view an individual’s IRA assets in separate compartments. Here is an example to demonstrate: Let’s say you have $95,000 in a Rollover IRA and $5,000 to a non-deductible IRA that you plan to convert to Roth. Upon conversion, the IRS will view 95% of your $5,000 conversion as taxable, since 95% of your IRA assets are pre-tax. Needless to say, if you plan on executing this strategy you should consult a tax professional.
If you do have outside IRA assets, don’t throw in the towel on this idea. There could be a case to be made for paying the taxes and converting those assets to Roth. Another potential opportunity to fund a Roth is if your 401(k) offers after-tax contributions and in-service distributions. I’ll save those topics for another day!
Lincoln Financial Advisors does not provide legal or tax advice. Adam Weingartner is a registered
representative of Lincoln Financial Advisors Corp. Securities and investment advisory services offered through Lincoln Financial Advisors Corp., a broker/dealer (member SIPC) and registered investment advisor. Insurance offered through Lincoln affiliates and other fine companies. Bluestone Wealth Partners is not an affiliate of Lincoln Financial Advisors Corp. CRN-2905762-011420