As a career professional, you likely have a traditional 401(k) and individual retirement account (IRA). However, as a high earner, you may exceed the income limits to fund their Roth counterparts. Nevertheless, the IRS allows high-earning individuals to convert a traditional IRA to a Roth IRA–regardless of income–through a strategy called a backdoor Roth IRA. If you’re over age 50 and nearing retirement, here are five reasons you may want to consider a Roth IRA conversion.
A Backdoor Roth IRA Shifts Your Tax Liability to the Present
Traditional retirement account withdrawals are taxed at your ordinary income tax rate in retirement. Since tax rules and rates change over time, you may end up in a higher tax bracket down the road.
On the other hand, a backdoor Roth IRA shifts your tax liability to the present. In other words, you’ll be taxed on the amount you convert at your current ordinary income tax rate. However, any withdrawals in retirement will be tax-free if you’re over age 59 ½ and satisfy the five-year rule. This gives you a higher degree of flexibility when it comes to planning your distribution strategy and taxes in retirement.
A Backdoor Roth IRA Reduces Future RMDs
A major advantage of Roth IRAs over traditional IRAs is that Roth IRAs have no required minimum distributions (RMDs). This can offer you several planning benefits.
First of all, RMDs are taxed. Converting your traditional retirement assets to a Roth IRA can reduce your future tax burden if you don’t need the income. In addition, your money can continue to appreciate within a Roth IRA tax-free for the duration of your retirement.
Lastly, a backdoor Roth IRA means your beneficiaries won’t pay taxes on RMDs either. However, it’s important to note that per the SECURE Act, most non-spousal beneficiaries must withdraw all funds from an inherited IRA–traditional or Roth–within 10 years of the original owner’s death.
Roth Conversions Can Be Powerful Estate Planning Tools
A backdoor Roth IRA has several advantages when it comes to estate planning. Since a Roth has no RMDs, your account balance can grow tax-free for the benefit of your beneficiaries. In addition, the SECURE Act changed the rules for IRAs inherited by most non-spousal beneficiaries.
Specifically, anyone who inherited a traditional IRA prior to 2020 could take RMDs based on their own life expectancy or that of the original account owner. Essentially, this feature allowed beneficiaries to “stretch” the inherited IRA based on their longer life expectancy.
The SECURE Act eliminates the stretch IRA provision for most non-spousal beneficiaries. Instead, beneficiaries who don’t meet the eligible designated beneficiary classification must withdraw the entire balance of an inherited IRA account within 10 years.
This change is especially consequential for traditional IRA beneficiaries, who may be in peak earning years during the withdrawal period. Indeed, the same 10-year rule applies to inherited Roth IRAs. However, a backdoor Roth IRA may allow your beneficiaries to keep more of their inheritance.
You May Have Lower-Income Years
If your earnings tend to fluctuate due to bonuses, commissions, or other types of variable compensation, you may have years when your income is lower than normal. Similarly, if you’re a business owner, your income may vary year over year.
Taking advantage of a backdoor Roth IRA in a lower-income year means your tax bracket may also be lower than usual. If you can plan accordingly, a Roth IRA conversion may be more tax-efficient than it would be otherwise.
You May Be in a Higher Tax Bracket in Retirement
Many retirees find themselves in a higher or equal tax bracket in retirement due to pensions and other retirement income. Unfortunately, taxable distributions can quickly drain your retirement savings. A backdoor Roth IRA can help mitigate this risk.
Converting to a Roth before commencing pension benefits, Social Security benefits, and other sources of income that drive you into a higher tax bracket can make sense for a few reasons. First, you won’t need to withdraw money from a Roth IRA in retirement unless you need it. In addition, any withdrawals are tax-free if you’re over age 59 ½ and you meet the five-year rule. Lastly, converting to a Roth before your income increases will be more tax-efficient than waiting until you are fully retired.
Be Sure to Weigh the Benefits of a Backdoor Roth IRA vs. the Cost
A backdoor Roth IRA can be a solid financial planning strategy for those nearing retirement. Still, you’ll need to weigh the benefits against the costs. In other words, the taxes you’ll pay in the year you convert your funds.
For example, you’ll want to make sure you have enough time to recover from an upfront tax hit. If the Roth conversion is for estate planning purposes, be sure to consider taxes from a total family perspective. It’s usually a good idea to work with a trusted financial advisor, who can help you weigh your options.
As independent, fee-only financial advisors, Milestone Asset Management Group can help you assess whether a Roth IRA conversion makes sense given your retirement and estate planning goals. To find out more, schedule a call.
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