Backdoor IRAs: Another way for high earners to save on taxes in retirement
Unless you've filed an extension with the Internal Revenue Service, the 2016 tax year is now history. You're probably ready to take a break from thinking about taxes at all, but there is no time like the present to consider how you might save on future payments to Uncle Sam — particularly if you're a high income earner ramping your saving for your golden years.
There is a great strategy that high-earning households could be overlooking that may save significant taxes in retirement: setting up a Roth Individual Retirement Account.
Roth IRAs are attractive for several reasons. While funded with after-tax dollars, any earnings are tax-deferred and withdrawals in retirement are tax-free. In addition, Roth IRAs are not subject to the minimum annual withdrawals required from traditional IRAs during retirement, so they can also be an excellent tax-planning tool.
Because there are income limits to open a Roth IRA, most people earning high salaries don't believe a Roth IRA is an option. Under the law, a single person with an annual adjusted gross income of $133,000 or more and a married couple making more than $196,000 cannot directly fund a Roth IRA.
However, since an IRS rule change in 2010, there have been no income limits on converting funds initially made to traditional IRAs into Roth IRAs. By taking advantage of this strategy, many people can implement a long-term strategy to have more tax-free funds available in retirement.
Here's how this "backdoor" Roth IRA strategy works.
Most high earners are likely saving the maximum allowed in company 401(k) plans. After all, it's an easy way to save and consistently invest money that will grow over time, but there is a limit to these contributions. The ceiling for 2016 before-tax contributions is $24,000 for people age 50 and older. So how can a person save more and reduce their taxes?
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The first step is to open an after-tax "non-deductible" traditional IRA and, if you are married, one for your spouse, too. Anyone is eligible to open a non-deductible IRA, even if contributing the maximum to a company 401(k) plan. For example, a person earning $300,000 annually who participates in his or her company's 401(k) plan can open a non-deductible IRA and contribute up to $5,500 annually, or $6,500 if over age 50. If married and both spouses are age 50 or older, they can contribute a combined $13,000.
Once the after-tax IRA has been set up, the second step is to convert it into a Roth IRA.
People setting up a new after-tax IRA should consult with a financial advisor on how quickly this account can be converted into a Roth IRA. If the account can be converted quickly, any taxes owed could be minimal. The more time between the initial contribution and conversion to a Roth IRA, the more likely these funds will generate a gain. If this occurs, taxes will be due on the gains.
Here's an example of how an individual can employ this strategy.
One of my clients who earns more than $500,000 annually makes the maximum contribution to his company's 401(k) and does not have an existing IRA. He and his wife, who are both more than 50 years old, will each make $6,500 in after-tax contributions into their respective traditional IRAs for 2016.
They will do this again for 2017 (contributions must be made before April 18 for the 2016 tax year). Once these IRA contributions are made and the administrator processes the paperwork, the funds can be converted into Roth IRAs.
As part of the client's overall investment portfolio, we plan to continue this strategy for the next several years, which will give him and his wife a tax-free source of retirement income. If my clients make these contributions for the next 10 years and decide to retire, they'll have $130,000 — plus any investment gains — in their Roth IRAs.
Keep in mind that there are several caveats to this strategy, so consult a tax advisor before making any decisions. For one, a person with existing IRAs funded with pretax contributions will owe taxes when converting this money to a Roth IRA. Of course, this makes the strategy less appealing.
However, for people without existing IRAs, the long-term benefit of this back-door Roth IRA strategy is that money in a Roth IRA will grow tax-free, and these funds are not taxed when the money is withdrawn during retirement.
Just as a diversified investment portfolio is a sound strategy, diversifying income into a group of different retirement vehicles can help people get more from their savings in retirement.
— By Mike DeWitt, wealth advisor at Brightworth
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