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:
- 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 (example below)
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:
- Joe and Stacey are married and have a daughter, Julia, who is 5. They plan to contribute $3k per year every year until she heads off to college at age 18. They have taxable income of $150k per year.
- Virginia’s top marginal bracket is 5.75%, and that bracket begins at only $17,001 of income.
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:
- In the 13 years we contribute, we’ll have put in $39k total into the plan. If we assume a 6% rate of return over that investment period, that gives us a balance of $56,646
- The capital gain will be $17,646 ($56,646 – 39,000). At $150k taxable income, your Federal capital gains rate is 15% and your state rate remains the same at 5.75%
- The resulting tax bill dodged on capital gains is $3,662 ($17,646 x 20.75%)
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.