This week I’m going to cover how to use Roth IRAs for tax planning to reduce lifetime tax liabilities, how to get more money into a Roth IRA using the “backdoor Roth” method and, finally, cover how you can use a Roth for college savings.
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In a previous post I discussed the rules and benefits associated with Roth IRAs.
Let’s start with obvious. The tax code can be a bit crazy, confusing, complicated and a general pain in the you know what. But if you know how to maneuver around the numbers, limits and rules, there are ways to take advantage of the labyrinth that is our tax system.
Let’s start with Roth IRA Conversions.
Roth IRA Conversions
At the moment, for example, with income tax rates at historically low levels, filling up lower income tax brackets with Roth conversions can be a great tax planning strategy and one we are recommending and using frequently at my firm.
Roth IRA conversions are a way of leveling out and reducing your lifetime tax liabilities. You are basically paying taxes now on your pre-tax retirement accounts, in order to avoid paying taxes later.
I know what you’re asking. Why would you want to pay taxes before it’s absolutely necessary?
Consider two possible scenarios.
First, let’s say you’re retired, no longer have earned income and you have $600,000 in an IRA.
Then, let’s say you need access to all that money right now because you have to pay a load of medical bills, maybe long-term care, to buy a second home or get a bunch of facelifts and Botox. You’re probably getting the picture that it doesn’t matter what you need the money for, you just need it.
If you have no other income and need to take all $600,000 out of your IRA in a single year, you will pay around $153,000 in taxes (rounded figures).
Now, imagine you worked with me and we converted $100,000 per year over the last 6 years. You would have paid under $8,800 per year for a total of around $53,000.
So, by using conversions, you saved approximately $100,000 in taxes and your money is now in a tax advantaged Roth IRA.
I hope I have your attention now.
How does this work, you ask?
Well, let’s say you are married couple that is recently retired and no longer has earned income. Since you no longer have ordinary income, you can convert up to around $100,000 of your IRA to a Roth IRA in the 10% and 12% brackets after the approximately $24,000 in deductions (rounded figures).
By “filling up” the lower marginal tax brackets, you would pay only 10% and 12% tax on the Roth conversion and again have all the tax-free advantages of the Roth IRA moving forward.
When should you consider Roth conversions?
- If you have a temporary dip in income for whatever reason and you think your tax rates will be higher in the future. This could happen throughout your life; it doesn’t necessarily have to be at retirement age.
- Next, if you’re in or getting close to retirement and ready to start planning for it.
- Finally, legacy planning. Unlike traditional IRAs, Roth IRAs have no required minimum distributions (RMDs). The money just grows until you need it or your retirement is over.
Now, I want to cover a couple more ways to get money into a Roth IRA. My firm doesn’t use these quite as much since we focus on retirees, but these two strategies can be huge while in the accumulation phase of your financial life.
Backdoor Roth IRA
If the income limits of a Roth IRA keep you from contributing, you may want to consider contributing to a regular IRA and then converting it to a Roth. There are no income limits to contribute to a traditional IRA, so you contribute and then convert it to a Roth. (Note: There are income limits on what can be deducted when contributing to a traditional IRA.)
If you are single and your modified adjusted gross income (MAGI) is above $137,000 or married and your combined MAGI is over $203,000, your income is too high to contribute to a Roth, at least directly. High-income clients can still get money into a Roth IRA with a backdoor Roth IRA.
There is a two-step process. First you can contribute to the non-deductible IRA and then you convert the account to a Roth IRA.
Two things to pay attention to with this process.
- The IRA aggregation rule considers all IRA accounts as one big retirement account and distributions must be treated accordingly. Or you can just put other IRAs into your current 401(k) as a work around because a 401(k) isn’t subject to the aggregation rule.
- The "step transaction doctrine" states that if the steps of a conversion are completed within too close of a time frame, the IRS may determine that they were really part of one transaction and the IRS would treat the transaction like a Roth IRA contribution made by a high-income individual. This breaks the tax code.
Michael Kitces (a guru in the financial planning world) recommends waiting a full year between the contribution and conversion to avoid this.
Next, we have a mega backdoor Roth.
Mega Backdoor Roth
This strategy allows relatively large chunks of money to be stuffed into a retirement account.
It’s similar to the backdoor Roth, but done within a 401(k) plan. It consists of making an after-tax 401(k) contribution and then converting it to a Roth account using the after-tax money.
These can be great for business owners with a solo 401(k) plan or any 401(k) plan that allows for after-tax contributions.
If you are over age 50, you can make $62,000 in total contributions to 401(k) plans in 2019 ($56,000 if you’re under 50). This includes both employee and employer contributions and after-tax contributions.
Last, I’m going to cover using a Roth IRA for college savings.
Roth IRAs for College Savings
This is a lesser-known benefit of Roth IRAs where they show, yet again, how they can be used as great planning tools. Roth IRAs can be used to pay for college expenses.
When considering a Roth IRA account for college savings, the first thing to consider is how old you will be when your child is in college. If you will be 59 ½ or older, (and you’ve met the five-year holding requirement), you can use your Roth dollars to pay for anything, including college, with no tax implications or penalties.
Now, if you will be younger than 59½ when your child is in college, you can still use Roth money for college expenses, but your withdrawal will not be qualified. How can you do this and pay no taxes or penalties? Well, only the earnings portion of your distribution would be taxable, not the contribution portion.
The idea is to withdraw the contribution portion of your Roth dollars and leave the earnings portion so you pay no income tax. Non-qualified withdrawals from a Roth IRA take contributions first and then earnings, so you could theoretically withdraw up to the amount of your contributions and not owe income tax.
The key to this strategy is that the 10% early withdrawal penalty that normally applies to withdrawals before age 59½ is waived if you use your Roth IRA to pay for college. This is true even if you have had the account for less than 5 years.
So, if you use Roth dollars to pay for college expenses and you’ll be younger than 59½ when your child is in college, you might owe income tax (only on the earnings portion of the withdrawal), but you won’t owe a penalty.
One last perk for having a Roth IRA is that retirement assets aren’t counted by the federal or college financial aid formulas. Therefore, your Roth account balances won’t affect your student's financial aid.
*As always, be sure to consult your tax consultant or financial planner before implementing any changes. But the flexibility and benefits of a Roth IRA account should not be overlooked with almost any plan.
Can we save you large chunks of money in taxes with Roth Conversions? Feel free to reach out to us. we would be happy to help! Shoot us an email or start with a quick 15-minute phone conversation by visiting “our process” on our website.