Whether you're a young professional climbing the corporate ladder or a mid-career physician looking for ways to maximize savings, your income may have climbed above the eligibility threshold for a Roth IRA. As we layer trillions of debt upon our nation through the pandemic, our country is bound to face rising tax rates in the future. Whether its 5 years, 10 years, or 20 years from now, we are likely to see tax rates move higher; it's difficult to argue tax rates will continue to operate at historically low levels. So, what are you doing to hedge against rising tax rates in the future? Here in West Michigan, we're helping physicians, small business owners, and mid-career professionals utilize the backdoor Roth strategy, when possible.
Roth or Traditional IRA?
Let's first revisit the difference between the two IRA's. The main difference between the two is the timing of income taxes. Roth contributions are non-deductible, meaning the contributions are taxed upfront, while traditional IRA's may receive a tax deduction which can reduce your taxable income in the year the contribution is made. However, the distributions from the traditional IRA typically become taxable upon withdrawal in retirement, whereas the Roth distributions are tax free as long as certain conditions are met. For a Roth IRA, generally, you can withdraw direct contributions anytime and backdoor contributions after a five-year waiting period. To avoid taxes and penalties on withdrawn earnings, however, you must be at least age 59½ and the Roth IRA must be at least five years old. In either case, please consult a tax advisor to determine your tax liability.
Is the Roth or Traditional IRA best for your situation? Depends on several factors. Analyzing your current and future tax situation, the types of accounts you currently own, and the impacts of contributions on your financial plan should be considered. We suggest working with your financial planner and accountant to solidify a plan before locking in your decision for the year.
Backdoor Roth Strategy
The backdoor Roth is a financial planning strategy that bypasses the income limits for high earners to get money into a Roth IRA. The Backdoor Roth involves nondeductible IRA contributions that are converted to a Roth IRA. First, you may be eligible for the Roth IRA: see the chart below that outlines an individual or married couple's eligibility for Roth IRA contributions. For example, if you are single and make more than $139,000 MAGI, you will not be eligible to make a Roth IRA contribution for 2020. Therefore, you may have the potential to utilize the Backdoor Roth strategy.
The strategy works like this:
To make a backdoor Roth contribution, you simply make a nondeductible contribution to a new traditional IRA and then convert it to a Roth IRA. Sounds simple, right? Not so fast. The backdoor Roth works best if you do not have an existing traditional IRA. If you have an existing traditional IRA, you need to be mindful of the pro-rata rule, which could trigger a significant unexpected tax on the conversion from the non-deductible IRA to the Roth. The best way to understand the rule is to consider the "cream in the coffee" analogy: when you add cream to a cup of coffee, the two become mixed and its impossible to separate two if you take a spoonful. Essentially, this is the consequence of utilizing the backdoor strategy with existing traditional IRAs. For tax purposes, all of your deductible traditional IRAs (this includes Simple IRAs and Sep IRAs) are included in the tax calculation on the conversion. See this article for more on the pro rata rule: https://www.kiplinger.com/article/retirement/T046-C032-S014-how-to-leverage-a-backdoor-roth-ira.html
Education is Key
Does the strategy make sense for you? When it comes to choosing between a Roth IRA, Backdoor Roth IRA and a traditional IRA, there is no right answer. Everyone is going to have a different preference depending on when they want to pay their taxes, withdraw their distributions and more. However, it’s important to compare the pros and cons of each before making a decision if you want to make the optimal choice for you and your family. If you're in the Greater Grand Rapids area and you are a physician, small business owner, or mid-career professional, please feel free to contact us to run the numbers on the strategy that makes the most sense moving forward.
Preparing for your retirement may seem like a daunting task, but deciding which retirement plan suits your needs the best is the first step to securing your assets, future and well-being for the coming years. Whichever decision you make, it’s important to understand that our needs are constantly changing, so be sure to not only think about your current preference but also what you might prefer in the years to come.
About the Author:
Michael Steinebach is a Financial Advisor serving the Greater Grand Rapids area. Born and raised in Rockford, Michigan, Michael is a focused on helping individuals in the community make prudent choices with their money.