You may have dismissed Roth IRAs years ago if you didn’t meet the income eligibility. But did you know that you can convert traditional IRA funds into a Roth IRA by doing what’s called a “backdoor conversion”? You can convert funds to a Roth no matter what your income level is, and unlike traditional IRAs, your investment earnings are not taxed upon withdrawal.
The downside is that, because traditional IRAs are funded with pre-tax dollars, if you choose to convert to a Roth IRA, you’ll pay taxes on those tax-deferred dollars the year you make the conversion.
Is a Backdoor Roth IRA worth considering? In this post we’ll discuss how Roth IRAs can fit into a retirement strategy and overall wealth management. And, while there is no one-size-fits-all when it comes to any retirement planning — Roth IRAs being no exception — it may be helpful to build your strategy based on where you are in your retirement planning.
Scenario #1: You’re Young with Many Years Until Retirement
If you’re in your thirties or early forties, with an investment horizon of 30 or 35 years or more, you could convert a traditional IRA to a Roth and, depending on your outlook and assumptions, you could recoup the tax hit in your lifetime. Again, depending on your investment strategy, you may even realize additional tax-free growth. With Roths, there’s no required minimum distribution (RMD), so your Roth IRA can continue to grow well past age 70½ when traditional IRAs require RMDs. With this added flexibility, you can leave your Roth investments untouched, which can be an added benefit, particularly if they happen to be underperforming.Scenario #2: You’re Near Retirement and Need Your IRA Assets to Live On
Because you have fewer years for your retirement nest egg to grow, chances are good that if you convert assets to a Roth, you won’t earn back the money you pay in taxes. Plus, if you’re still in your prime wage-earning years, your tax bracket may be higher now than during retirement. Which means you could end up paying more taxes if you convert than you would if you held onto a traditional IRA and paid taxes during retirement. Another factor to consider is your estate plan. If you have a taxable estate, some people prefer to convert their traditional IRA savings to Roth IRAs, so their heirs are relieved of any tax burden they’d inherit with traditional IRAs. You can learn more about this by talking to an estate planning advisor.Scenario #3: You’re Financially Secure and You Don’t Need IRA Income to Live On
For wealthy individuals, IRAs tend to be a relatively small part of their overall wealth — and often a source of frustration. Many of our clients find IRAs to be a hassle. There’s the RMD they need to worry about each year. And they recognize they’re horribly inefficient for income tax purposes. When selling a non-retirement investment, capital gains are taxed at a preferred rate. In contrast, an IRA distribution is taxed at the highest marginal tax rate. Relative Value Partners sees a variety of ways that clients choose to manage their IRAs. Some invest in something like a Berkshire Hathaway stock that never pays dividends. Others, particularly those who are charitably inclined, are taking advantage of a rule that came out a few years ago, which allows them to satisfy the RMD by making charitable contributions directly from the IRA. If you are planning a donation, this solution can provide an interesting workaround to the RMD. And for those who have philanthropic giving as part of their estate plan, we’re seeing many of them name a charity as the beneficiary of a traditional IRA. Still others are converting traditional IRAs to Backdoor Roth IRAs as part of their estate planning strategy. You are essentially prepaying the estate taxes now. But the benefit is you are passing on a Roth IRA as a tax-free asset to your heirs. To be happy and comfortable with this decision requires being willing to look at the long-term benefit over two generations.Five Tips for Roth IRAs
#1 Consider Investing in a Roth IRA Through a 401(k) Plan
More employers are allowing distribution into a Roth IRA. When contributing to a Roth via a 401(k), there is no income eligibility requirement to meet. Because it’s a post-tax contribution, there are no immediate tax savings in your paycheck, but it’s a way to grow Roth IRA assets without having to convert a traditional IRA and pay a significant tax bill.#2 Consult Your Tax Specialist Before Considering a Backdoor IRA
It’s important to have your CPA or accountant run through your tax liability if you choose to convert traditional IRA money into a Roth. In the year of conversion, the rollover amount is treated as income, which can impact all types of other financial considerations like a bump up in tax bracket, loss of deductions or financial aid eligibility for those with children near college age.#3 Timing is Key
The ideal time for a conversion is when the market is down. Until this year, the IRS had a recharacterization rule that provide a certain degree of protection if you did a Backdoor Roth conversion and the market dropped. However, now you incur tax liability at the moment of conversion, making rollover timing more critical. You’ll want to consult with your financial planner or wealth advisor around the best time to convert.#4 Consider a Roth After Maxing Out 401(k) Contributions
If you need to save for retirement and want to put aside more money than the 401(k) limit, it’s worth considering adding a traditional IRA as part of your savings strategy. You can roll it over into a Backdoor Roth each year, which will create no more tax liability than if you were directly contributing to a Roth IRA — and your savings will grow tax-free. This will only work if you do not have other existing IRA assets, as when making a conversion the portion subject to tax is determined by the ratio of taxable IRA assets to all IRA assets.#5 The Impact of Tax Reform
Should you expect to see more Roth conversions this year given the new tax rates? As a planner, I tend to take a long-term view of situations. Taxes are a big source of revenue. While I can’t predict or guarantee anything, history indicates that the new tax rates are at a much lower level than average. I’m fairly comfortable wagering that tax rates 10, 20, 30, 40 years from will be higher than they are now. While that’s not a reason to convert, it may play into timing of the conversion.Bottom Line: Seek Professional Advice
In general, a Backdoor Roth may be most ideal for high-net-worth individuals looking to maximize what they pass to their heirs while being as income and tax efficient as possible. For those in this situation, it’s a compelling strategy. No matter which type of investor you are, if the idea of a Roth IRA is appealing to you, reach out to someone who can run then numbers and give you advice based on your unique situation.About Jeff Fosselman, CPA, CFP®, JD
With more than a decade of experience in the industry, Jeff Fosselman is instrumental in delivering financial planning strategies and counsel to high-net-worth individuals. As Senior Wealth Advisor for Relative Value Partners, Jeff provides comprehensive advisory services in estate planning, income tax planning, cash flows, asset allocation and other financial planning areas.Disclosure
Information contained in this article is obtained from a variety of sources which are believed though not guaranteed to be accurate. Past performance does not indicate future performance. This article does not represent a specific investment recommendation. No client or prospective client should assume that the above information serves as the receipt of, or a substitute for, personalized individual advice from Relative Value Partners, LLC which can only be provided through a formal advisory relationship. Clients of the firm who have specific questions should contact their Relative Value Partners counselor. All other inquiries, including a potential advisory relationship with Relative Value Partners, can be directed here.Relative Value Partners merged with Kovitz Investment Group Partners, LLC as of August 2024. All Insights are opinions of the author as of the posting date. Any graphs, data, or information in this publication are considered reliably sourced, but no representation is made that it is accurate or complete, and should not be relied upon as such. This information is subject to change without notice at any time, based on market and other conditions. Past performance is not indicative of future results, which may vary.