Tax-Diversify Your Portfolio Part 3: Back-Door Roth IRAs – Advanced
For those of you with income higher than the limits to contribute directly to a Roth IRA, you can still achieve tax-free savings through a “back door” Roth strategy: contributing first to a Traditional (non-deductible) IRA, followed by conversion to Roth.
This “Contribute-then-Convert” strategy provides a tax efficient way to tax-diversify your accounts provided that you do not have other IRAs that contain pre-tax contributions. These IRAs with pre-tax savings include rollover IRAs from 401ks or 403bs, and SEP-IRAs from self-employment. The existence of these other IRAs changes the math involved in the conversion calculation, and lessens the tax efficiency of the strategy. The non-taxable part of a Roth contribution is calculated according to the following formula:
Tax basis of all IRAs
—————————————————— X Amount of IRA converted to Roth = NONTAXABLE
Value of all IRAs at end of year of conversion
Example: If you had contributed $11,000 to a Traditional IRA (and taken no tax deduction), you have an IRA with a tax basis of $11,000 (the total of after-tax contributions). If you convert that IRA to a Roth when its value is $11,050, the non-taxable part of the conversion is ($11,000 / $11,050) x $11,050 = 0.9955 x $11,050 = $11,000. $11,050 converted – $11,000 not taxable = you’ll owe tax on $50.
Example: Same facts as the previous example, but now let’s say you also have a rollover IRA (all pre-tax savings from a 401k) valued at $100,000. If you convert the $11,050 IRA to a Roth, you’ll have to include the $100,000 balance of the rollover IRA. In this case, the non-taxable part of the conversion is ($11,000 / $111,050) x $11,050 = 0.0991 x $11,050 = $1,095. $11,050 converted – $1,095 not taxable = you’ll owe tax on $9,955.
In each case, you only converted $11,050 to Roth, but the tax consequences were vastly different, given the presence of the other IRA money.
If you have other IRAs with pre-tax savings that will dilute your Roth conversion, there are some things you can do. The effort to tidy up accounts to lay the foundation for a tax efficient Contribute-and-Convert strategy is not immaterial. But the long-term benefits are numerous:
- Never having to take taxable required minimum distributions
- Tax-free compounding on savings until you need the money
- When you need your Roth savings, you can take it out tax free
- Your heirs can take it out any income from a Roth you leave them tax free
- A Roth can reduce the impact of the new American Taxpayer Relief Act of 2012 (“ATRA”), which brought back the phase-out of itemized deductions and gave us the new net investment income tax
- If you believe your accounts will grow in value, converting a smaller account balance results in a smaller tax liability today, with any future growth now occurring in a tax-free account
Here are some tips if you find yourself in a Roth conversion situation complicated by other IRA assets:
Planning Tip #1: If You Have an Old IRA – Roll It to Your 401k
Many employer plans will accept rollovers of previous employer’s plan balances. If you rolled a previous employer’s 401k or 403b to a rollover IRA, check with your current employer’s plan administrator to see whether you can roll those old retirement plan funds into your current plan. You need to complete this “roll-up” of your old 401k/403b into your current plan in the tax year before you convert any other IRA balances to Roth. One drawback of using your existing employer plan is that will be limited to the investment choices in your plan.
Planning Tip #2: If You Have an Old SEP – Roll It to Your New Solo 401k
If you are self-employed, you can use a variation on Tip #1. While a SEP-IRA would be included in the Roth conversion calculation, a Solo or Independent 401k (available to self-employed workers) would not be. You can roll a SEP into a Solo 401k, and that takes the SEP-IRA out of the Roth conversion calculation, provided you moved the SEP to the Solo 401k in the tax year before the conversion of any other IRA balances to Roth. Note that here you would not necessarily be limited in your investment choices.
Planning Tip #3: If You Have an Old IRA – Accelerate Charitable Giving
If you can’t move an old IRA with pre-tax savings into a qualified retirement account (i.e., 401k, 403b) and you are charitably inclined, you could accelerate your charitable giving using a donor-advised fund (DAF) to “bunch” future years’ giving into the tax year of the conversion. You need to consider your long-term financial needs, but if you can afford it, your contribution to a DAF in the year of a Roth conversion can help off-set some of the tax from the conversion.
Planning Tip #4: Note Each Spouse Treats His/Her IRAs Separately
Sometimes one member of a client couple can do a tax efficient conversion, while the other cannot, so we look at conversion of each person’s accounts. Note that the Roth conversion calculations for couples is based on what each spouse owns; if he has a rollover IRA that would make a Roth conversion strategy less tax efficient, and she has no rollover IRA, she can do a tax efficient Roth conversion. His rollover IRA does not affect her Roth conversion calculation, even if they are filing a joint tax return.
Satori Financial LLC has been working with clients over the past several years to clean up their IRA accounts, rolling them into existing 401k and other employer plans where possible when the investment choices in those plans are solid, to great tax advantage. The rules can be complicated, so proceed with caution, or better still, seek advice from a tax professional familiar with Roth IRA conversion strategies. Contact Satori Financial LLC to see how we can help you.