Many investors mistakenly believe that their income levels limit their options to qualified employer retirement plans when it comes to tax-advantaged investing. Yet, a novel strategy called a backdoor individual retirement account can help highly compensated clients save an estimated $250,000 in taxes over their lifetimes.
While the tactic can help investors accumulate wealth for retirement, it can also be used by advisors to strengthen client relationships by demonstrating novel strategies for managing taxes.
There is no income limits for individuals and married couples seeking to contribute to traditional IRAs. However, the ability to do so on pretax basis is phased out based on income. For example, married couples with modified adjusted gross incomes of $116,000 or more that have access to employer retirement plans can only make non-deductable contributions.
Unfortunately, qualified withdrawals from the accounts are treated as income for tax purposes, so while the accounts allow for a deferral of taxes on investment returns, they do not provide the advantages of Roth IRAs, which impose no taxes on investment gains. Income limits on making Roth IRAs, however, typically prevent highly compensated clients from using the accounts.
That’s where the backdoor IRA comes in. Clients under the age of 50 can deposit $5,500 into a non-deductible IRA each year regardless of their income. Clients age 50 or older can deposit up $6,500 each year. In the process, they can then take advantage of generating tax free investment returns by converting the accounts into Roth IRAs.
By converting the accounts promptly after establishing the traditional IRAs, furthermore, clients will be less likely to have gains that would be taxed when the conversions are made. In making the conversion to a backdoor IRA, the long-term savings results can be impressive. For example, someone who starts IRA investing at age 30 and contributes the maximum allowable amount each year could generate a $460,000 nest egg by age 65, according to estimates by The Vanguard Group.
If the client kept those assets in the traditional IRA, more than 15% would go to taxes once required distributions are made. By age 90, the investor could shell out more than $250,000 in taxes assuming the account continues to grow. By converting to a Roth IRA, however, each year clients can avoid having to paying taxes when they make qualified withdrawals.
In assessing the strategy, advisors should consider that a portion of the assets rolled into a Roth IRA may be taxed as ordinary income if the client already has deductable IRA accounts. The amount of the nondeductible IRA to be rolled over is divided by the total amount of the rollover amount combined with the amount of assets in deductible IRAs in order to calculate the portion of the rollover that will be taxed.
Highly compensated individuals, of course, may have limited assets in deductable IRAs as their income may have prevented them from utilizing such vehicles. At the same time, any taxes paid upfront when making the conversion may be a worthwhile expense when considering the long-term advantages of using Roth IRAs.
Advisors should also be prepared to explain to clients the other benefits of Roth IRAs. For example, the accounts have no minimum required distributions, so clients can continue to generate tax-free earnings late into their retirement years or even until their death if they plan on leaving the assets to estate beneficiaries.
In addition, assets pulled out of Roth accounts as qualified distributions aren’t counted toward income, so the withdrawals will not put clients in higher tax brackets. That can also help clients keep their reportable income low, which can help them qualify for lower premiums on means tested programs, such as Medicare.
In a related manner, advisors should also keep in mind opportunities for clients to convert traditional deductable IRAs into Roth IRAs in a tax efficient manner. When completing such conversions, clients must pay taxes on the amount being converted.
In cases where clients may face lower incomes—and lower taxes rates—because of unemployment, it may be appealing to make the conversions. Conversions may also be appealing after market corrections that have reduced the total amount of assets in clients deductable IRAs. With reduced assets, clients will pay less when the accounts are rolled over but will be positioned to capture tax-free market gains that are likely to occur after a market correction.