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High-income households can use what’s called a “backdoor Roth” to utilize a Roth IRA despite the program’s standard income restrictions. This can be an effective way to build a tax-free stream of income for your retirement, and it is a completely legal strategy.
Whether this method will reduce your taxes depends heavily on your tax rates now versus what you’ll pay in retirement. For some high-earners, a Roth IRA can actually be a money loser if it means you end up spending more on taxes today than you will save on taxes in retirement.
A Roth IRA is what’s called a “post-tax” retirement account. This means that you contribute to it with money that you’ve already paid taxes on. Then, in retirement, you make withdrawals on both your contributions and any growth completely tax-free. The idea is that it’s more expensive upfront to build a Roth IRA compared with a pre-tax portfolio like a traditional IRA or 401(k), but you save taxes on your portfolio at its peak value as a retiree.
However, Roth IRAs also have income limits. For 2024, if you’re single and make less than $146,000 or married and make less than $230,000, you can contribute up to $7,000 for the year. This contribution limit begins to shrink and phase out up to the ultimate income caps of $161,000 and $240,000 for single and joint filers, respectively. For high-earners beyond these figures, this would lock you out of a Roth IRA.
The solution to this is what’s called a backdoor Roth, though. With this approach, you open a traditional IRA (which has no income limits) and a Roth IRA. You contribute money to the traditional, pre-tax IRA, then, either in one lump sum or periodically, convert the funds over to your Roth IRA.
Since the IRS puts no income limits on Roth rollovers, you can build a fully funded Roth IRA regardless of household income. Of course, you’ll need to be prepared to pay taxes upfront on all of that money, so take that into consideration as well. You may also find it helpful to work with a financial advisor when planning a backdoor Roth.
When you convert money to a Roth IRA, you will need to pay income taxes on the entire amount in the tax year that you make the conversion. For example, if you move $50,000 from your traditional IRA to your Roth IRA, you would add on $50,000 to your taxable income that year, potentially pushing you into higher tax brackets in the process.
It’s important to manage your cash flow appropriately for this tax event. Unlike portfolio withdrawals, a conversion doesn’t generate spendable cash that you can use to pay these taxes. You will need to have the money on hand.
Also, remember to account for the pro-rata rule. If your IRA contains a mix of deductible and non-deductible contributions, you will pay taxes based on their proportion in your account. You cannot simply volunteer to move all of the nondeductible contributions and avoid conversion taxes.
It’s not uncommon for households to convert their IRA on a regular basis, say each year or every several months. This can help maximize your untaxed gains, but conversion taxes apply each time you roll money over. Ongoing transfers can also help get around the Roth IRA’s cooldown period, also known as the 5-year rule.
A Roth IRA offers several benefits. Primarily, because you pay taxes on the funds upfront, this portfolio will grow tax-free and you will pay no taxes on your withdrawals. It also has no required minimum distributions (RMDs), giving you more flexibility in your financial planning.
High-earning households may not find it helpful to save money with this vehicle. In fact, the more you make, the easier it could be to end up paying more in conversion taxes than you’ll actually save on income taxes in retirement.
The standard rule of thumb is that a Roth IRA is typically better if you expect to pay higher taxes in retirement than you do currently. On the other hand, a traditional IRA can be optimal if you expect your tax rates in retirement to go down. For example, say that you pay an effective rate of 20% in taxes while working and have $50,000 to invest:
Roth IRA: You pay $10,000 in taxes and invest the other $40,000
Traditional IRA: You pay $0 in taxes and invest the full $50,000
Now, say that your portfolio has doubled in value by the time you reach retirement. For taxes, you now pay an effective rate of 22% and withdraw all of the funds:
Roth IRA: You pay $0 in taxes and keep $80,000
Traditional IRA: You pay $22,000 in taxes and keep $78,000
This is where the rule of thumb comes from. The Roth would still leave you with $80,000, but the traditional IRA’s after-tax value would drop to $78,000.
On the other hand, say that your effective tax rate had dropped to just 15% in retirement. The Roth would then generate the same $80,000, but the traditional IRA’s value would surpass it at $85,000 after taxes. That’s why this decision always comes down to whether your tax rates will be higher or lower in retirement compared to your working life.
For a high-earning household who’s making $300,000, it could be helpful to speak with a financial advisor. A backdoor Roth might help reduce your taxes depending on your anticipated retirement income and current investment strategy, but there’s a chance that you might actually spend more than you save in the long run.
A financial advisor can help you build a comprehensive retirement plan. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Planning for your retirement income can be a complicated and speculative process. But knowing your tax bracket isn’t. Once you know what you plan on withdrawing, try using an income tax calculator.
Keep an emergency fund on hand in case you run into unexpected expenses. An emergency fund should be liquid — in an account that isn’t at risk of significant fluctuation like the stock market. The tradeoff is that the value of liquid cash can be eroded by inflation. But a high-interest account allows you to earn compound interest. Compare savings accounts from these banks.
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