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If you are a relatively high earner, you may not be able to make Roth IRA contributions due to the associated income limits. In that case, you might want to consider a conversion instead, also known as a “backdoor Roth.”
The advantage of this is that you avoid any income taxes on withdrawals from the assets you convert. The downside is that this comes with a significant upfront tax bill, money you could otherwise have invested. However, if your goal is to avoid taxes in retirement, a Roth conversion can be an effective option.
Do you have questions about managing taxes after retirement? Talk to a financial advisor today.
A Roth IRA has two limitations that don’t apply to most other tax-advantaged retirement accounts. The first is a ceiling with a low contribution. As of 2024, those under 50 cannot contribute more than $7,000 per year to a Roth IRA, while that limit is $8,000 per year for people over 50. For example, this is about one-third of the 401(k) limit.
However, Roth IRAs also have income limits to contend with. More specifically, you cannot contribute to a Roth IRA if your income exceeds $161,000 for single filers or $240,000 for joint filers. The IRS is also steadily lowering your Roth IRA contribution limits at incomes between $146,000 and $161,000 for individual taxpayers and $230,000 and $240,000 for joint filers.
For high earners who want to take advantage of the after-tax benefits of a Roth IRA, these income caps are a problem. One possible solution is a Roth IRA conversion, also known as a “backdoor Roth.”
In a conversion, you take assets in an existing pre-tax account, such as a traditional IRA or 401(k), and transfer them to a Roth IRA all at once. Because this is not considered a contribution, neither the income limits nor the contribution limits apply. You can switch as many assets as you want, up to your entire pre-tax portfolio, and there is no limit on the number of times you can switch funds.
In this situation, if you are an individual filer, an income of $200,000 puts you above the income limits for Roth contributions. That means a conversion is the only way you can put assets into a Roth IRA. But filing jointly keeps you under the income limit and allows you to choose any combination of contributions and conversions.
The benefits of a Roth conversion are already covered in the question posed for this article. This is one way to avoid/limit paying federal income taxes in retirement. With a Roth IRA, you pay taxes on your contributions, but not on your withdrawals or investment growth. Since you ideally get a lot more out of your portfolio than you contribute, this should provide a significant tax benefit over time.
Now it’s important to note that a Roth IRA does not protect you from state or local taxes, if any. That said, these are generally quite small compared to federal income taxes. What’s more, since Roth withdrawals don’t count as taxable income, they don’t apply to calculating taxes on Social Security benefits.
The result is that converting your retirement account to a Roth IRA will save you most, if not all, of your taxes in retirement. This is unlike a pre-tax account such as an IRA or a 401(k), where you do pay income taxes on your withdrawals and that money does apply to your taxable Social Security income. This obviously means that you will then not be able to take advantage of the income deduction benefits that pre-tax accounts provide while contributing to them.
A Roth conversion comes with a large upfront tax bill.
When you make a Roth conversion, the value of any assets you convert are added to your tax bill for that year. For example, say you have $2 million in a 401(k) and convert the entire amount. This will save you taxes on your withdrawals, but you will owe income tax on that $2 million in the tax year in which you complete the transfer.
This can be a problem because it raises taxes without the associated cash flow to pay the bill. This is why many people do large Roth conversions in stages, so that they only trigger the tax bill a little at a time. Keep in mind that you also only pay tax on that first conversion. A key benefit of a Roth conversion is that you don’t pay taxes on any future growth of the account.
This is the trade-off with a Roth IRA. When you invest in a Roth account, you pay taxes on the money you put into it. This is money you could have invested, creating the trade-off of potential growth for guaranteed tax savings.
You’ll probably want to resolve this tension based on tax rates, although a financial advisor can help you make an exact decision. If you expect your tax rate in retirement to be higher than your current rate, or if you don’t think you would invest the savings from a pre-tax account, a Roth IRA may be worth it. If you expect to pay a lower tax rate in retirement than you do now, a pre-tax account can save you more money in the long run.
Finally, every Roth IRA is subject to the IRS’s pro-rata rule. This rule applies if you have both a pre-tax IRA and an after-tax Roth IRA. In that case, you must withdraw all withdrawals proportionally from both accounts. For example, say you have $1 million in an IRA and $500,000 in a Roth IRA (a 2/1 ratio). If you withdraw $60,000 in a given year, you will need to withdraw $40,000 from your Traditional IRA and $20,000 from your Roth IRA (a 2/1 ratio). This may limit your flexibility when it comes to using this account.
Setting up a Roth conversion depends on exactly how you want to structure your tax payments and when you need the money. When you make a Roth conversion, you must leave the money in the account for at least five years, so plan for short-term cash flow in the meantime.
To set this up, you’ll need a pre-tax account such as an IRA or a 401(k). You can then move your money in different ways.
The simplest option is a one-time transfer in one go. In this case, you move your entire portfolio to a Roth IRA. This allows you to maximize your tax-free returns, but can come with a high upfront tax bill.
Another option is to set up phased transfers. In this case, you convert your portfolio step by step over several tax years. This allows you to manage the tax bill caused by each year’s conversion(s), but it limits your tax-free returns.
Finally, you can perform continuous or automatic conversions. You can do this with an IRA or with 401(k) plans that allow the option. In this case, you contribute money to a pre-tax account and leave it for the desired period of time. Then transfer the account’s assets to a Roth IRA, or you can set up an automatic transfer if your account allows it.
A financial advisor can help you plan a suitable Roth conversion strategy. Match a fiduciary advisor with SmartAsset’s free tool.
As an individual making $200,000 per year, you cannot contribute to a Roth IRA if you are single, but you can if you are married and filing jointly. However, you can convert money from a pre-tax account to a Roth IRA through a process known as a “backdoor Roth.” This allows you to minimize federal income taxes in retirement at the cost of a large tax bill in the short term.
A financial advisor can help you draw up a comprehensive retirement plan. Finding a financial advisor does not have to be difficult. SmartAsset’s free tool matches you with up to three vetted financial advisors serving your area, and you can have a free introductory meeting with your advisors to decide which one you think is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
A Roth IRA may seem like an easy choice, and it’s true that the tax savings from this program are incredible. But that doesn’t make this an automatic choice, so before converting any assets, make sure a Roth IRA is a good choice for you.
Have an emergency fund on hand in case you encounter unexpected expenses. An emergency fund should be liquid – in an account that is not at risk of significant fluctuations like the stock market. The trade-off is that the value of liquid cash can be eroded by inflation. But with a high-interest account, you can earn compound interest. Compare savings accounts from these banks.
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