and Paul Layton, CFP®

As you save for your golden years, a retirement account allows you to invest in a tax-advantaged manner. Contributions to retirement accounts are usually tax-deferred, so they have the chance to grow over time without causing a tax bill every year.

There are many types of retirement accounts. In this guide, we’ll focus primarily on individual retirement accounts (IRAs).

Account type	Contributions	Dividends and growth	Distributions
Traditional IRA	Pre-tax	Tax-deferred	Taxed as ordinary income
Roth IRA	After-tax	Tax-deferred	Tax-free*
Traditional IRA with non-deductible contribution	After-tax	Tax-deferred	Partially taxed as ordinary income

*Earnings on Roth contributions will be taxed unless withdrawals are a qualified distribution as defined by the IRS.

When you contribute to an IRA, you’re essentially making a deal with the government to get a tax benefit as an incentive for saving for your retirement. There are a few different ways this can work:

• With a traditional IRA, you get a tax deduction for contributing if your income is below the contribution threshold and you meet other requirements. In other words, you’re putting in pre-tax money. When you take the money out someday, the distribution is taxed as ordinary income.

• With a Roth IRA, you don’t get a tax deduction for contributing. In other words, you’re putting in after-tax money. But if you follow all the rules, when you take money out someday, qualified distributions are tax-free. Your contributions may be withdrawn at any time without taxes or penalties.

• If your income is too high to get the tax deduction on a traditional IRA, you can still contribute on an after-tax basis. When you take money out, distributions are partially taxable as income depending on how much of the IRA contributions were made on an after-tax basis. One strategy for dealing with this is a backdoor Roth conversion, which we discuss below.

What is a traditional IRA?

Generally, anyone that has earned income during the year can make contributions to a traditional IRA, even if they’re currently enrolled in their employer-sponsored retirement plan such as a 401(k).

Be aware of the income limits and conditions that determine whether you can take a deduction when contributing to a traditional IRA. Talk to your financial and tax professionals to decide whether it may be better to contribute to a traditional or Roth IRA.

There is a special “spousal IRA” rule that allows non-employed spouses to contribute to an IRA even if they have no earned income, which can be useful to increase overall household retirement savings.

Two factors determine whether a traditional IRA contribution is deductible:

• Modified adjusted gross income (MAGI) threshold: If your MAGI is above the threshold, you can only make non-deductible (after-tax) contributions to a traditional IRA.
• Access to an employer sponsored plan: In addition to the MAGI requirement, being part of an employer-sponsored plan can also affect the deductibility of an IRA contribution.

For traditional IRA contributions, you can generally take a tax deduction as long as your modified adjusted gross income (MAGI) is below the maximum threshold.

• If your MAGI is close to the maximum threshold but not above it, you may be able to take a deduction on part of the traditional IRA contribution.

Generally, investment income (like dividends) and growth are tax-deferred while inside of your traditional IRA.

Distributions from a traditional IRA are generally taxed as ordinary income. In most cases, if you take money out of a traditional IRA before age 59 ½, you’ll be assessed an additional 10% penalty tax on top of the income tax.

At a certain age, the IRS requires you to withdraw a certain amount from the traditional IRA every year so they can start collecting the tax. These are called required minimum distributions (RMDs). Depending on when you were born, your RMD age may be 72, 73 or 75.

What is a Roth IRA?

A Roth IRA is an individual retirement account where you contribute after-tax but receive future distributions of earnings tax-free, as long as you follow all the rules. So a Roth IRA provides no tax benefit today, but future tax-free distributions can be very advantageous. Since your contributions are made with after-tax dollars, they may be withdrawn at any time without taxes or penalties.

Generally, a Roth IRA distribution will be tax-free if you’re older than 59 ½ and you’ve owned a Roth IRA for at least 5 years.

You can contribute to a Roth directly if your MAGI is under a certain threshold. If your MAGI is close to the maximum threshold but not above it, you may be limited to making a partial Roth IRA contribution.

Be aware that traditional IRAs and Roth IRAs share a maximum contribution amount. For example, if you max out your Roth IRA then you cannot contribute to a traditional IRA.

Benefits of a Roth IRA:

☐ Tax-free distributions and more tax flexibility in retirement

☐ Not subject to required minimum distributions during owner’s and typically spouse’s lifetime

☐ Tax-free money to heirs

☐ You can withdraw your contributions at any time, if needed, without tax or penalty

☐ Can act as a hedge against tax rates going up in the future

☐ Can be beneficial for young savers who have a long time horizon to retirement, low current income, and expect to have higher income in the future. Someone in this situation might contribute to their Roth today, while later switching to pre-tax contributions when their income goes up

Roth conversions

A Roth conversion is when you transfer money from a traditional IRA to a Roth IRA. The money moved into the Roth will be taxable as income in the year of the conversion, so the hope is that you’ll save more in taxes from later Roth distributions than you’re paying in taxes now.

The two main reasons that someone may convert a traditional IRA or pre-tax retirement account to a Roth are reduction of taxes in retirement and legacy planning

 ☐ Generally speaking, a Roth conversion might make sense for someone who is in a lower tax bracket today than they expect to be in in the future.

☐ While tax rates are one consideration, you should also think about opportunity cost of the taxes paid. If that money had been otherwise invested, you may be missing out on potential growth opportunities.

☐ There are also complexities around the timing of Roth conversions that should be discussed with your tax professional. Essentially, each conversion comes with a five-year clock before you can take a tax-free distribution.

☐ A Roth conversion needs to be carefully considered before actually converting because they are irreversible. For this reason, if someone is unsure what their income will be for the year, they may want to wait until the end of the year to make a decision about Roth conversion.

1. Reduction of taxes in retirement

Roth IRAs and retirement distributions:

☐ Roth IRAs allow for increased flexibility when it comes to taking money out of your account in retirement. Planning withdrawals strategically can help create tax-saving efficiencies based on your brackets in any given year.

☐ Tax-free distributions from Roth IRAs can come in handy during years with higher than usual expenses.

☐ Roth conversions will help lower RMDs  in the future because you are moving money out of those accounts that are subject to the required distributions.

Keep in mind, if you think you’ll be in a lower tax bracket in the future, it  may not make sense to do Roth conversions today. You could simply defer the tax, by leaving the money in your traditional IRA, and then pay the lower tax rate when you take distributions in the future.

2. Legacy planning

What happens to your wealth after your lifetime? Let’s discuss the considerations around leaving IRAs to your heirs.

☐ A spouse who is inheriting a traditional IRA is able to treat it as their own account so they generally won’t have to take RMDs until they turn 72, 73 or 75.

☐ Remember that Roth IRAs are not subject to RMDs; this includes a spouse inheriting a Roth IRA.

☐ If a non-spouse, such as an adult child, inherits an IRA, they will usually be subject to required minimum distributions.

If you don’t need the assets during your lifetime, converting them to a Roth can sometimes make sense.

☐ You can allow the Roth IRA to remain invested without having to take RMDs, during your lifetime and typically a spouse’s lifetime.

☐ If your heirs receive a traditional IRA, they will pay tax on the distributions, but they generally won’t pay tax on inherited Roth IRA distributions.

☐ Paying taxes on a Roth conversion today reduces the value of your estate, which can in turn reduce any federal estate tax you may owe in the future. However, this is generally not an issue for most families because the federal estate tax exemption is currently very high (although some state estate tax exemption thresholds may be lower).

Considerations

How strong is your retirement plan? We would suggest that you may want to focus on your long-term goals first before considering what types of assets your heirs would receive.

Are you in a higher tax bracket than your heirs would be in the future? This is often a guess but if you think they’ll be in a lower tax bracket, then it could make more sense for them to inherit pre-tax assets and then pay tax on distributions at a lower rate.

Non-deductible IRA contributions

As we discussed earlier, your MAGI will determine if your traditional IRA contribution is deductible.

☐ If your MAGI is too high, your contribution will not give you a tax deduction. It will be non-deductible.

☐ Any non-deductible contributions made to your traditional IRAs are called “basis.”

☐ Any earnings or growth on the original contribution is considered tax-deferred. When you take money out of your account, some of the money will be non-taxable and the other part will be taxable as ordinary income.

Let's take the following as an example:

A $6,500 non-deductible contribution grows to $8,000 = $6,500 basis with $1,500 tax-deferred growth

*You should be aware of the special tax reporting requirements when you have non-deductible contributions. Be sure to connect with your tax professional to discuss the details.

Takeaways

• Tracking your “basis” over the years can be a cumbersome process.

• If you don’t track basis properly it could lead to you paying tax on the contribution as well as the withdrawal.

• Even if you do track it properly, the gains associated with the contributions are taxed as ordinary income.

• If your income is too high to take an IRA deduction, you may want to make a Roth IRA contribution.

• If you cannot contribute to the Roth IRA, based on income limitations, you may want to consider a taxable investment account. Long-term capital gains on investments held in taxable investment accounts are taxed at a lower rate than your ordinary income.

Non-deductible contributions and “backdoor Roth conversions”

The strategy of making a non-deductible IRA contribution and then converting the contribution to a Roth IRA is often referred to as a “backdoor Roth conversion.”

☐ As we discussed above, if your income exceeds the threshold, you can’t contribute directly to a Roth IRA. But making a non-deductible IRA contribution and then converting to a Roth brings the same result, hence the name “backdoor.”

☐ Ideally, the conversion would take place before any growth occurs in the account.

There are no income limitations to make a non-deductible IRA contribution or a Roth conversion.

☐ Ideally, a backdoor Roth conversion allows long-term investment growth in a Roth IRA for later tax-free withdrawals, versus a traditional IRA where distributions are taxed as income.

☐ There are some tax reporting headaches with non-deductible contributions. A Roth conversion allows you to reduce some of the long-term reporting requirements.

☐ Keep in mind that backdoor Roth conversions may not be around forever. Congress could decide to disallow them or change the rules at some point.

☐ Backdoor Roth conversions can seem like a simple concept, but in some cases, things get a bit more complicated due to the “pro-rata” rule.

What is the pro-rata rule?

The pro-rata rule determines how much of your Roth conversion is taxable. This comes into play when you have both pre-tax and non-deductible (basis) contributions in your IRAs.

☐ If you only have pre-tax dollars in your traditional IRAs, the pro-rata rule doesn’t apply; 100% of any conversion is taxable.

☐ This rule can have costly tax consequences for someone thinking they are doing a backdoor conversion but not accounting for all their pre-tax IRA assets. Their Roth conversion will be proportionately taxed by the percentage of pre-tax dollars in their IRA.

☐ For example, if 25% of your traditional IRA balances are basis and 75% are pre-tax, then 75% of any Roth conversions would be taxable as ordinary income.

The pro-rata rule in more detail

☐ The pro-rata rule applies when you have a mixture of pre-tax and non-deductible (or basis) dollars within your traditional IRAs.

☐ Traditional, SEP, and SIMPLE IRAs are all included in the pro-rata calculation. Roth IRAs and non-spousal inherited IRAs are not included.

☐ Be aware that all your IRA accounts with pre-tax money count toward the pro-rata rule, regardless of where they are held.

☐ The pro-rata rule only applies to individuals rather than the entire household. One spouse may be subject to the pro-rate rule while the other is not.

How is the pro-rata rule calculated?

PRO-RATA RULE EXAMPLE

IRA BALANCE $123,500 (all pre-tax contributions)

• Ted wants to make a Roth IRA contribution, but his MAGI is too high.

• So he makes a $6,500 nondeductible IRA contribution, bringing the account balance up to $130,000.

• Ted has heard about backdoor Roth conversions and thinks he can convert his recent nondeductible contribution without paying any “extra” taxes this year.

RESULT:

After the non-deductible contribution, Ted’s IRA is 95% pre-tax and 5% after-tax basis. Due to the pro-rata rule Ted can’t convert only the basis, so in this case his conversion is 95% taxable.

This scenario is not ideal. Here’s why:

• The contribution is not tax-deductible.

• Ted still had to pay tax on the majority of the conversion due to the pro-rata rule.

• While Ted isn’t technically paying double tax on this conversion, it can feel like a surprise “extra” tax bill for this year.

• Now Ted has to keep track of his IRA basis every year going forward to ensure proper reporting. While not difficult, it can be a pain.

Rolling over a pre-tax employer plan after conversion

Be aware that even if you do a backdoor conversion properly, it could still be taxable if you roll your employer retirement plan to an IRA later in the year.

☐ The pro-rata calculation includes the balances of all pre-tax IRAs on 12/31 of the tax year. So if someone thought they did a non-taxable backdoor Roth conversion earlier in the year and later rolled their employer retirement plan to a traditional IRA, a portion of the conversion might be taxable.

☐ The Tax Cuts and Jobs Act made Roth conversions irreversible, so you may want to do your Roth conversions later in the year to ensure you understand the full tax-year picture.

TIMELINE

You open a new traditional IRA in September, make a $6,500 non-deductible contribution, and execute a backdoor Roth conversion. This conversion should be nontaxable since you don’t have any pre-tax money in any IRAs.

You leave your employer in December and roll your pre-tax 401(k) to a traditional IRA. Since you now have pre-tax money in an IRA on December 31, it’s likely that most of the conversion from September will be taxable due to the pro-rata rule.

Conversions inside of a 401(k) aka “mega backdoor Roth conversions”

If pre-tax IRAs are part of your portfolio, backdoor Roth IRA conversions can be less advantageous due to the pro-rata rule. Another option is to look at your 401(k).

☐ Some 401(k)s have an option to make after-tax contributions to the 401(k) and then roll the after-tax contribution into a Roth 401(k) under the same plan.

☐ After-tax contributions into a 401(k) are typically made after the full “employee deferral” contribution is made. In other words, you would look to max out the employee pre-tax deferral first and then make after-tax contributions up to the allowed maximum.

☐ This strategy is often referred to as a mega backdoor Roth conversion. It may be  most advantageous when automatic conversions of after-tax contributions occur so that the any growth from the converted after-tax amount happens inside of the Roth 401(k).

☐ Not all employer plans allow for this strategy, so you may want to check with your plan administrator to see if it’s an option.  In addition, certain IRS retirement plan rules may limit the amount of after-tax contributions a highly compensated employee can make to the plan.

Mega-backdoor Roth conversions

EXAMPLE

• Susan has excess cash flow that she would like to contribute to a Roth account.

CHALLENGE

• Susan’s income is too high to contribute directly to a Roth IRA.

• Susan has large pre-tax IRA balances, so the pro-rata rule would make regular backdoor Roth IRA conversions inefficient from a tax perspective.

• Because of Susan’s high income, an outright conversion of her pre-tax IRA assets to Roth would trigger large income taxes.

• Susan learns that her 401(k) plan allows after-tax contributions that can then be converted to the Roth side of the 401(k).

• Susan already makes the maximum $22,500 (in 2023) salary deferral and her employer makes matching contributions totaling $10,500.

• This could potentially allow Susan to make up to $33,000 of non-deductible contributions to her 401(k) that could be immediately converted to Roth.

• Some plans limit maximum after-tax contributions, so Susan will need to confirm the rules by contacting the plan administrator.

$66,000 maximum contribution to a 401(k) > $22,500 employee salary deferral > $10,500 employer contributions > Up to $33,000 after-tax contribution and conversion

Roth conversion vs. long-term capital gains

EXAMPLE

Raj and Asha are in their first full year of retirement.

• They file taxes jointly and take the standard deduction.

• They don’t need money from the portfolio for living expenses this year.

• They have a small traditional IRA and large taxable brokerage accounts. Their future retirement withdrawals would primarily come from their brokerage accounts.

• They’re wondering if it would make sense to convert some of their traditional IRA to Roth and hopefully save on taxes later.

CONSIDERATION

Strategic Roth conversions or long-term gains harvesting can be a great planning opportunity if done properly in a year with little to no income.

Roth conversions can help reduce RMDs in the future because you move money out of your traditional IRA. Large IRAs can cause significant required distributions, but in this case, it may not be much of a concern given their smaller IRA balances.

Raj and Asha may want to  consider realizing long-term capital gains to effectively raise their cost basis in their brokerage account. By doing this, they  could reduce taxable gains realized in the future.

The tax on a Roth conversion would still be relatively low but may not be as effective given their RMDs will likely be low already.

Are Roth conversions right for you?

Reasons to consider a Roth conversion:

☐ You are in a lower tax bracket today than you expect to be in in the future.

☐ You think the tax efficiencies of a Roth IRA in retirement outweigh the cost of the conversion today.

☐ Providing your heirs tax-free assets is a high priority.

☐ You have no pre-tax IRA assets and make too much to contribute directly to a Roth, so maybe a backdoor Roth conversion is a viable option.

Reasons why a Roth conversion may not be right for you:

☐ If you are receiving Affordable Care Act Subsidies while on a marketplace healthcare plan, Roth conversions will increase your income and likely reduce your subsidies.

☐ If income is low enough, you may want to consider realizing long-term capital gains while staying within the 0% federal long-term capital gains bracket.

☐ If you’re 63 or older, a Roth conversion may raise your Medicare premiums.

☐ If you are collecting Social Security, with low income, a Roth conversion could make more of your benefits taxable.

☐ If you need the money within five years, you may run into some complications with the five-year rules.

The bottom line

As you can see, IRAs in general, and Roth conversions specifically, are both complex topics with many factors to consider. A great place to start the conversation around IRA savings or Roth conversions is by working with your financial advisor before ultimately making any decisions with your tax professional.

 

 

RO3215360-1123