This episode of Retire Your Way Radio covers how to use Roth IRAs for tax planning. This includes how to reduce your lifetime tax liability by using Roth IRA conversions, how to get more money into a Roth IRA using the “backdoor Roth” method, and how you can use a Roth IRA for college savings.
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This episode was originally published Oct. 30, 2019. These show notes have been updated 1/27/2021 to reflect 2021 income brackets and current regulations.
In a previous post, I discussed the rules and benefits associated with Roth IRAs.
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
A Roth IRA conversion involves taking pretax money from a traditional IRA and converting that money to after-tax money in a Roth IRA to enjoy the benefits of a Roth IRA. The Roth conversion is considered income in the year of the conversion, and you will need to pay income taxes on that income based on your current income tax rate.
Then you will never pay income taxes on that money again (once the account is qualified) because Roth IRAs give you tax-free earnings and withdrawals in retirement.
At the moment, with income tax rates at historically low levels, filling up lower income tax brackets with Roth IRA 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 pretax retirement accounts to avoid paying taxes later.
I know what you’re thinking. Why would you want to pay taxes before it’s absolutely necessary?
Scenario 1: without Roth conversions
First, let’s say you’re retired, you no longer have earned income, and you have $600,000 in a traditional IRA.
Then, let’s say you need access to all of that money right now because you have to pay a load of medical bills, pay for long-term care, 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 $150,000 in taxes (rounded figures). This assumes you are married filing jointly and puts you in the 35% tax bracket for 2021.
For those of you that like to see how that's calculated, here you go:
|Married Filing Jointly 2021 tax brackets||Taxes calculated|
|10% for first $19,900||= $1,990|
|12% for $19,900 to $81,050||= $7,338|
|22% for $81,051 to $172,750||= $20,174|
|24% for $172,751 to $329,850||= $37,704|
|32% for $329,851 to $418,850||= $28,480|
|35% for $418,851 to $574,900||= $54,617|
|($600,000 IRA balance - $25,100 standard deduction = $574,900)|
Scenario 2: with Roth conversions
Now, imagine you worked with me, and we converted $100,000 per year from your IRA to a Roth IRA over the last 6 years. You would have paid under $8,600 per year for a total of around $52,000.
So, in this scenario, by using Roth 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 a 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 from your IRA to a Roth IRA in the 10% and 12% tax brackets after the approximately $25,000 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.
And again, for those of you that like to see how that's calculated:
|Married Filing Jointly 2021 tax brackets||Taxes calculated|
|10% for first $19,990||= $1,990|
|12% for $19,991 to $74,900||= $6,589|
|($100,000 Roth conversion - $25,100 standard deduction = $74,900)
Total taxes in 2021
Total taxes after 6 years
(assuming same tax rates and brackets)
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.
- If you’re in or getting close to retirement and ready to start planning for it
- 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 traditional IRA and then converting that money to a Roth IRA. There are no income limits to contribute to a traditional IRA, so you contribute and then convert 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) for 2021 is above $140,000 or you are married and your combined MAGI is over $208,000, 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 the use of a backdoor Roth IRA.
There is a two-step process. First you make a nondeductible contribution (after-tax money) to an IRA, and then you convert that account to a Roth IRA.
IRA aggregation rule
One thing 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. This means if you make a nondeductible contribution to an IRA, but you also have a rollover IRA with pretax money, the amount you convert will be a combination of after-tax and pretax money. As a workaround, you could put other IRAs into your current 401(k) because a 401(k) isn’t subject to the aggregation rule.
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.
A mega backdoor Roth is 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 the after-tax money to a Roth account.
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 $64,500 in total contributions to 401(k) plans in 2021 ($58,000 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.