Provided By Phil Behnen, CPA, CFE
As the filing deadline for tax returns approaches, many people are taking a step back to analyze their finances and determine whether they’re paying more taxes than necessary. Retirement plans are one area where the decisions you make today can have lasting tax implications further down the road. It might be easy to take a “set it and forget it” approach to saving for retirement, but proactive planning can help you save more efficiently by reducing your tax burden.
Roth IRA plans, which offer tax-exempt savings, have been a popular option since Congress created them in 1998, but there are limitations on eligibility. For example, couples that earn more than $194,000 annually cannot fund a Roth IRA account. However, a few years ago congress enacted a new law allowing more affluent families the opportunity to enjoy the benefits of the Roth IRA.
Since 2010, anybody can make the conversion from a traditional IRA to a Roth IRA regardless of income. This is called a backdoor Roth IRA, and it’s a completely legal and even standard investing practice for high-income earners. As always, it’s a good idea to consult with a tax professional before taking action.
Basically, the process starts by making a regular, non-deductible contribution to a traditional IRA through your IRA custodian. After the contribution posts, you can convert it by buying shares in a Roth IRA and selling shares of your traditional IRA to fund it.
Because the initial contribution was already non-deductible, the taxes on it have essentially been paid. You’ll only need to pay taxes on the difference between the converted value and the amount contributed, which should be minimal if the money was in your account for a short period of time.
One thing to consider before making a conversion is the IRA pro-rata rule. This rule stipulates that when calculating the taxable income from a Roth conversion, you must include all non-Roth IRAs in your name (including SIMPLE and SEP IRAs). To calculate the amount of the conversion that is not taxed, you must divide the total of after-tax contributions by the total balance across all IRAs (excluding Roth IRAs).
To get around this, you can either roll all your traditional IRAs over to a Roth account or an employer-sponsored 401(k). However, it could cost you a lot in taxes and earnings depending on your circumstances. If you own a practice that’s operating at a loss, you can avoid paying the conversion tax by offsetting losses from the business against income from the conversion.
Timing Your Conversion
Whether or not a Roth conversion makes sense for your situation can only be answered on a case-by-case basis. One important guideline is if you cannot afford to pay the taxes owed out of pocket or out of a taxable account, than a conversion would probably not be recommended since the benefits are substantially less. Most people have a tendency to postpone paying taxes as long as possible, but if you can afford to take the hit now it will limit your exposure to taxes on your investment profits down the road.
In general, if you have to use IRA savings to pay taxes triggered by shifting them to a Roth, you might be sacrificing too much principal up front to make the deal worthwhile. It’s definitely not advisable to execute a conversion during your peak earning years. Delaying the conversion until you reach retirement age makes sense if you’ll be in a lower income tax bracket during retirement than you are currently. Other factors to consider are how you plan on paying for the income tax bill due on the conversion, how long the Roth IRA will remain untouched and the size of the IRA in the context of your estate.
At the end of the day, you want to make sure the taxes you pay to convert the account are less than what you would save on subsequent tax-free withdrawals. If you have a large enough net worth, you could also avoid potential estate tax liabilities because the income tax created by the conversion would reduce the value of your gross estate.
If you don’t have other pre-tax IRAs at your disposal, than a backdoor Roth would be an ideal option for high-income individuals looking to gain IRS-approved access to these tax-free accounts. Doing so will allow you to profit handsomely from your investments without having to give Uncle Sam his cut. It might sound too good to be true, and for complex transactions like this it’s best to consult with a tax professional before taking any action, but it’s definitely an option to be explored.
Advisory Services offered through Larson Financial Group, LLC, a Registered Investment Advisor. Securities offered through Larson Financial Securities, LLC, Member FINRA/SIPC. Tax services offered through MedTax, an affiliated company.
This article should not be construed as tax advice. You should consult with a tax professional that is familiar with your individual circumstances before taking any action.
Larson Financial Group, LLC, Larson Financial Securities, LLC and their representatives do not provide tax advice or services. Please consult the appropriate professional regarding your tax planning needs.