By David O’Neill, JD, CWM®
You may have noticed that the Tax Cuts and Jobs Act (TCJA) isn't all it's cracked up to be when it comes to your tax bill. High-earning families living in high-tax states and municipalities have found their deductions sharply limited (state and local taxes, mortgage interest, unreimbursed employee expenses, tax prep fees, etc.).
Under the new tax law, tax planning is even more important than before. In this series of articles, we’ll cover some easy ways to reduce your taxes when you have a high income. Tax planning is taking advantage of the rules today to save taxes in the future.
As usual, tax planning strategies depend on your circumstances, and these articles aren’t meant to provide tax or legal advice. They’re meant to help you to brainstorm some tax-lowering ideas so you can pay less and keep (or spend) more.
IRAs vs. Roth IRAs
Let's begin with a brief discussion of the difference between IRAs and Roth IRAs. You’ve probably learned that IRA deductions and Roth IRA contributions are subject to income limits and other retirement plan contribution limits. Fortunately, with a backdoor Roth contribution, you can get around these limits—with a catch.
The secret of a Roth IRA is you can save more tax-advantaged money toward retirement than in a traditional IRA. That secret lies in when you pay taxes and the annual contribution limits.
In theory, net IRA and Roth IRA withdrawals should be the same, given equal tax rates when the IRA and Roth IRA contributions are made and when they’re withdrawn. In fact, the rule of thumb is to make deductible IRA contributions when your tax rate is higher than it will be in retirement, and Roth contributions otherwise.
But here’s why the rule of thumb will let you down: The contribution limits are the same for both an IRA and a Roth. This means that you’re able to save more tax-advantaged dollars in a Roth than an IRA. If your retirement tax rate turns out to be 25%, you’ll have 25% more money in a Roth than a traditional IRA.
Moreover, IRA withdrawals (aka distributions) are counted as taxable income in retirement and subject to required minimum distributions (RMDs) once you reach the age of 70-1/2. This leads to a gotcha: IRA withdrawals count toward your “provisional income,” which is used to determine whether your Social Security payments are taxable. Moreover, it can also increase the adjustments in your Medicare premiums once you're on Medicare (due to what is known as the income-related monthly adjustment amount, or IRMAA).
Roth IRA money, on the other hand, is completely tax-free in retirement. Roth IRA withdrawals aren’t subject to RMDs, and withdrawals from a Roth IRA don't count toward provisional income when determining the taxation on your Social Security or Medicare premium calculation.
The good news is that even savers above the Roth IRA income limits can make a Roth IRA contribution to build tax-free savings—but there’s a catch.
Backdoor Roth Contributions
Backdoor Roth contributions work well for savers that don’t have high IRA balances (there’s a workaround for those who do) and don’t expect to be in a dramatically lower tax bracket in retirement.
How it works: You make a nondeductible IRA contribution up to the 2019 contribution limit of $6,000 (or $7,000 if you're 50 or over). Then you immediately roll the IRA account into a Roth IRA account and pay the taxes on any growth or income that has occurred since the initial contribution (almost $0). Voila, Roth IRA!
Beware the Pro-Rata Rule
The catch is the pro-rata rule. The pro-rata rule requires that your backdoor Roth conversions to be taxed proportionate to the amount of tax-deferred IRA savings that you have. As a gross simplification, if you were rolling over a $5,000 after-tax IRA contribution into a Roth IRA, and you have $95,000 of other tax-deferred IRA money, 95% of your backdoor Roth contribution would be taxable at your income rate.
Fortunately, there are ways to get around the pro rata rule. First, if you have small tax-deferred IRA balances or you're in a low tax bracket (e.g., 12%), you may decide just to pay the tax. Otherwise, you can roll your existing tax-deferred IRA accounts into an active 401(k) plan if the plan allows it. See your 401(k) Summary Plan Description (SPD) to see what your plan allows. (Our Gainesville, Va. financial planning firm is always happy to review our clients’ summary plan descriptions.)
Roth IRA contributions are a great way to save more tax-advantaged dollars toward retirement. Even if you’re excluded from making deductible IRA contributions or contributing to a Roth IRA, you can still build tax-free retirement savings with backdoor Roth contributions. Just be aware of the pro-rata rule and what you can do about it.
Although backdoor Roth contributions may not seem like much, a $6,000 annual contribution over 20 years compounded at 8% will leave you with almost $300,000—tax-free.
Schedule a complimentary consultation with a fiduciary financial advisor to discuss your personal situation.