We recently covered a Roth IRA conversion ladder as one potential strategy for converting 401(k) or traditional IRAs to a Roth IRA. But there are some other key strategies that are good for high-income earners to know.
First, why (and why not) a Roth IRA?
There are quite a few tax benefits to a Roth: funds grow tax free, you can take tax-free withdrawals in retirement, and there are zero required minimum distributions (RMDs).
Another perk is that Roth income is not considered in the income calculation when it comes to taxation of Social Security benefits and in determining Medicare premiums after age 65.
But be aware that these retirement accounts do come with some drawbacks.
For starters, there are income limits to a Roth. If your income is too high (based on your MAGI, modified adjusted gross income, and your tax filing status), then you aren’t allowed to contribute. In order to contribute directly to Roth IRA, your income must be under $198,000 (if married, filing jointly), $208,000 (if married, filing separately), or $140,000 (if single). (Note: there are “phase out” income ranges that allow you to make a partial contribution).
Another: If you’re already in retirement and not earning any income, then you aren’t able to contribute directly.
Contribution limits are also not as large as with a 401(k) or some other retirement plans: 2021 contribution limits are $6,000, or $7,000 if you’re 50 or older.
When it comes to taxes, Roth IRAs are the opposite of traditional IRAs. With traditional, you can deduct contributions in the year that you make them, providing you with a tax break in that year. However, you must pay taxes on both pre-tax contributions and earnings when you withdraw funds from your traditional IRA in retirement.
But with a Roth, there is no tax break in the tax year that you make contributions. The upside from a tax perspective is that you will benefit from tax-free withdrawals in retirement. If you think that tax rates will increase in the future or your taxable income will be higher in retirement than it is today, this upfront tax bill may be preferable.
Top Roth IRA Conversion Strategies
All that said, a Roth IRA can be a powerful vehicle for boosting your retirement savings. This is where conversion strategies come in: They involve taking funds from an existing retirement account (such as a 401(k) or traditional IRA) and converting them into Roth IRA funds, allowing you to legally work around some of the limitations in place.
Here are some conversion strategies that you should know about and discuss with your wealth advisor. Your wealth advisor is an invaluable resource in helping you see the ins and outs of any retirement strategy within the context of your financial plan, and can help you understand the tax implications of Roth conversions (which can get fairly complex).
Here are five Roth IRA conversion strategies to consider.
#1 Backdoor Roth conversion
This is one way for you as a high-income earner to fund a Roth, despite the income limitations. A backdoor conversion works by opening a traditional IRA, immediately converting funds to Roth IRA funds, and paying the taxes. You’ll then owe no further taxes when you withdraw those funds in retirement.
You can also do this with a traditional IRA that you’ve already established.
#2 Backdoor Roth conversion via 401(k) rollover
If you’re older than 59 ½, still working, and contributing to a 401(k), but your income exceeds the limit for contributing to a Roth, you have another “backdoor” option: Many employers allow you to roll your 401(k) balance into a traditional IRA, which you can then turn around and convert to a Roth IRA.
#3 Mega backdoor Roth conversion
There are three conditions that make this one possible: First, you have a traditional (pre-tax) 401(k) plan. Second, it allows after-tax contributions. Third, your plan permits in-service withdrawals or rollovers.
If these all apply, and you’ve maxed out your allowable pre-tax contributions, then you can save an additional $38,500 a year in a Roth IRA. The way this works is by contributing after-tax funds to your 401(k), then rolling it over into the Roth.
#4 Offset the cost of a Roth conversion with life insurance
It’s possible to use permanent life insurance to help offset the cost of a Roth conversion for the surviving spouse. If a married couple purchases a first-to-die policy, then the surviving spouse uses the proceeds to cover the cost of the Roth IRA conversion, the remaining Roth funds can provide tax-free retirement income for the surviving spouse.
#5 Time conversions strategically for maximum benefit
It’s not just about how you convert, it’s about when. A few examples include:
- Converting to a Roth IRA during a year when you have higher tax deductions in order to minimize the tax burden of the Roth in that year.
- Converting in a tax year when income is lower than expected.
- Using a downturn in the markets as a Roth IRA conversion window.
- Timing conversions prior to age-based milestones, including retirement and claiming Social Security.
- Waiting until the end of the year, when you have a more complete understanding of your projected income and tax situation for that year, to do a Roth conversion.
Roth IRA accounts can bring significant tax advantages, but whether or not one is right for you depends on your particular circumstances. If you’re a high-income individual and want to find out if you can benefit from a Roth IRA conversion, talk to us. Set up a time today.