The taxman keeps coming…
A couple of years ago, congress stealthily changed the law for most owners of retirement plans. Under the old law, if you left your IRA to a person, generally, they were allowed to withdraw the money ‘slowly’ over their life expectancy (popularly called a Stretch IRA). For most people, this meant twenty years or more for a child or fifty years or more for a grandchild. In most cases, the new law requires the IRA beneficiary to withdraw all funds within ten years of the owner’s death. For many beneficiaries, this means a forced withdrawal during their highest-earning years and, therefore, highest tax rate years. The law disproportionately affected the rich and good savers, so it passed with little resistance and will result in billions of extra income taxes for families who planned to use the stretch IRA strategy.
President Biden has promised significantly higher taxes for taxpayers making over $400,000 (joint return). His administration is also considering the elimination of long-term capital gains tax treatment. All of this comes together to make the Roth IRA more attractive for several reasons:
- Although you do not receive an income tax deduction for a Roth IRA contribution, your money grows tax-deferred, and withdrawals during retirement are income-tax-free as well.
- While your beneficiaries must, in most cases, withdraw the money from your Roth IRA within ten years of your death, one hundred percent of those withdrawals are tax-free. This avoids the problem of being an adult child beneficiary and receiving taxable income during your peak earning years (as would be the case with a traditional IRA).
- With a Roth IRA, you do not have the required minimum distribution (RMDs). For a traditional IRA, you must begin taking money out of your IRA by age seventy-two and then continue to do so annually based on your life expectancy.
If you make too much money, you are not eligible to contribute to a Roth IRA. For 2021, joint-filers making over $198,000 begin to phase out and entirely phase out at $208,000; single-filers making over $125,000 begin to phase out and fully phase out at $140,000. For a full contribution explanation, check out Schwab’s Roth IRA Contribution Limits Table.
There is a little-known strategy called the Back-Door Roth IRA Strategy. Here is how it works:
Step 1. Invest in a Traditional NON-Deductible IRA. There are no income limits for this, so everyone with earned income (plus non-working spouses of spouses with income) is eligible.
Step 2. Do a Roth IRA Conversion. There are no income limits for doing a Roth IRA conversion, so you simply ‘convert’ the money from your Traditional Non-Deductible IRA to the Roth Conversion IRA. Once the conversion is complete, your money will forever follow the Roth IRA rules, which include tax-deferred earnings and growth, no Required Minimum Distributions, and tax-free withdrawals during retirement for both you and your beneficiaries.
Caveat: When doing a Roth Conversion, you must pro-rate the Traditional Non-Deductible IRA money with any Traditional Deductible IRA money you have for income tax purposes and the portion related to the Traditional Deductible IRA must be reported for income tax purposes.
Solution: If you have a 401k or similar company plan, see if the plan will allow you to ‘roll over’ your Traditional Deductible IRA money directly into your 401k plan. Beginning the next calendar year, you are ready to start your Back-Door Roth IRA Strategy.
The Back-Door Roth IRA Strategy is a bit of trouble but well worth the effort. This is a strategy I personally use each year. Because of the potential complexities involved, be sure to consult with your financial or tax advisor.
Bottom Line: If you can manage it, you should consider doing a Roth IRA each year for you and your spouse if married. Limits for 2021: you can contribute up to 100% of your earned income to a maximum of $6,000 per person if you are under age 50 and $7,000 for someone over age 50. If you qualify, you can also contribute for a non-working spouse. If you are a high-earner, consider using the Back-Door Strategy.
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Secret Roth IRA Strategy
Rising income taxes make a Roth IRA more attractive, but higher-income taxpayers are ineligible:
- Joint filers making more than $198,000
- Single filers making more than $125,000
Secret: Back-Door Roth IRA Strategy:
Step 1. Invest in a NON-Deductible IRA (no income limits)
Step 2. Do a Roth IRA conversion
Caveat: Must pro-rate Traditional IRA to calculate conversion taxes
Solution: Roll Traditional IRA money into your company 401k
Stewart H. Welch, III, CFP®, AEP, is the founder of THE WELCH GROUP, LLC, which specializes in providing fee-only investment management and financial advice to families throughout the United States. He is the author or co-author of six books, including 50 Rules of Success; J.K. Lasser’s New Rules for Estate, Retirement and Tax Planning- 6th Edition (John Wiley & Sons, Inc.); THINK Like a Self-Made Millionaire; and 100 Tips for Creating a Champagne Retirement on a Shoestring Budget. For more information, visit The Welch Group. Consult your financial advisor before acting on comments in this article.
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