Backdoor Roth IRAs – The Why and How
Putting money in a 401(k) plan is essentially a bet that your tax rate in retirement will be lower than it is now. Generally, this is a safe bet – you’re not working, so you should have less income, and should be in a lower marginal bracket. However, it’s impossible to know whether or not that’ll definitely be the case. Your personal income situation or political factors can change a lot between now and retirement. It’s worth considering a mix of both tax deferred (401k, 403b, etc) and tax free (Roth). But what do you do if you make too much to directly contribute the max amount to a Roth ($196k for Married Filing Jointly/$124k for Single Filers for 2020)?
Let’s take a look at a simple example where a Backdoor Roth Conversion might be employed, and how to do so.
Dan and Rita are both 42 years old and make $300k a year between them. They already max out their 401(k) plans at work and do not have any other retirement accounts (this is important – if they have IRA assets, any conversion will likely be taxed according to the pro-rata rule).
While they’re pretty sure their tax rate will be lower in retirement than it is now, they want to have some money invested in a Roth IRA so that not all of their retirement accounts are subject to Required Minimum Distributions and hedge themselves a little against the possibility of higher tax rates down the road.
The steps for them to make a backdoor Roth conversion are as follows:
Open two accounts each – a Traditional IRA and a Roth IRA
Make non-deductible contributions to the Traditional IRAs ($6,000 each for 2020)
Wait. The duration of this waiting period has been the subject of debate – ask your advisor or tax preparer what they recommend. Personally, I think one month is sufficient.
Convert the $6k in the Traditional Account to the Roth IRA account. Your custodian will have a form to accomplish this
File an 8606 Form with your next tax return (see a completed example)
There are many factors to consider in a Backdoor Roth Conversion strategy – current income, forecasted future income, assumption of future tax rates, cash flow needs, current IRA assets, and more. The above is just a simple example of how to accomplish the strategy. To determine if it’s the right choice for you, start a conversation with us.