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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 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:
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. Consult your advisor and/or tax professional. The above is just a simple example of how to accomplish the strategy once you’ve determined it’s the right choice for you.
Let’s do simple example for my home state of Virginia:
The value of the state income tax deduction for contributing $3k this year is $172.50 ($3k x 5.75%). Doesn’t seem like a lot, right? Over 13yrs (age 5 to 18) that’s $2,242. Not nothing, but not an eye-popping figure, either.
Now let’s assess the capital gain tax savings:
So all told, Joe and Stacey get an actual dollar benefit of $5,904.
Tax rates, deductions on contributions, and plan options vary greatly state by state. There are also alternative strategies and vehicles for college savings that you can consider. Be sure to run the numbers yourself to determine if 529s make sense for you.
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