Taxes on your mind? I don’t blame you! We have a new presidential administration coming with very different aspirations for our current tax structure. Additionally, another massive stimulus is trying to make its way through Congress which begs the question, “how will this be paid for?”
There’s only so much we can control about income taxes during our working years. Unfortunately, we’re at the mercy of whatever tax rates are at the time.
But we do have more control over taxes during our retirement years! By using this retirement savings strategy, you can hedge against future unknowns of income tax rates.
Roth IRAs can help.
A Roth IRA is one option for retirement saving. Instead of getting a tax deduction now, contributions to a Roth IRA are made after-tax but are withdrawn tax-free in retirement.
However, being able to contribute to a Roth IRA is limited.
For married tax filers, only those with adjusted gross incomes below $198,000 can take advantage of the full Roth IRA contribution in 2021.
Try a “backdoor Roth IRA.”
If your income is too high to contribute, you can take advantage of a two-step strategy that opens up another door to the Roth, the “backdoor Roth.”
Contribute to a Traditional IRA.
Normally, contributions to a Traditional IRA net you a tax deduction. If kept in there, future withdrawals are fully taxable. But remember, our goal is to have some tax-free income in retirement.
While anyone with income can contribute to a Traditional IRA, the ability to deduct these contributions is also limited by income.
This means you probably will not get a deduction for your Traditional IRA. That’s fine! This is simply a non-deductible contribution.
Ask your IRA custodian to convert your Traditional IRA to a Roth IRA.
Anyone, regardless of income, can use Roth conversions at any time. The amount you convert does not count toward your annual contribution limit. If you have pre-tax money in your Traditional IRA, you count that as income on your taxes for that year.
However, if the only money in your Traditional IRA is the non-deductible contribution from Step 1, the conversion will be tax-free! Why? Since you did not get a deduction, this money has already been taxed.
And there you have it—a backdoor Roth IRA contribution.
Beware of this trap.
A backdoor Roth IRA contribution should only be done with careful planning and the approval of your tax advisor.
A common mistake is neglecting the other amounts in a Traditional IRA. The “pro-rata” rule determines how much of a conversion is taxable when there are both pre-tax and after-tax (non-deductible) contributions.
Say you have $94,000 in a Traditional IRA (all pre-tax). You would like to contribute to a Roth IRA, but your income exceeds the limits. You heard about the backdoor Roth IRA strategy and decided to do this with a $6,000 contribution.
Because you have an existing balance in your IRA, you can’t make a $6,000 non-deductible contribution and then convert only this contribution. In this scenario, the pro-rata rule dictates how much of your conversion is taxable and how much is a tax-free return of the after-tax contribution.
Total balance after contribution: $100,000
Pre-tax balance: $94,000 (94% of total)
After-tax balance: $6,000 (6% of total)
Thus, if you try to convert $6,000, only 6% ($360) will be tax-free. The other $5,640 will count as taxable income.
What’s right for you?
I get it—paying a lot in taxes isn’t fun. Using retirement accounts with an immediate tax deduction is an easy and effective way to lower your tax bill.
But you also need to have a plan for taxes in retirement. While we can’t control future tax policies, planning during our working years can mean significant future tax savings.
Stewardship advisors illustrate taxes in retirement and to find ways to hedge against future tax policies. Even if you like the backdoor Roth strategy but are hampered by the pro-rata rule, we can help find ways to get money into your tax-free accounts.
Schedule a time to discuss your options with us!