Q&A: Here’s a retirement tax trick: the mega backdoor Roth IRA

Dear Liz: I am a 32-year-old married father of two. My income is high enough to contribute to my kids’ 529 and custodial brokerage accounts. I’ve been able to max out my 401(k), health savings account and backdoor Roths for my spouse and myself. Next, I’m debating between starting a life insurance retirement plan (LIRP) or making after-tax 401(k) contributions because my plan allows mega backdoor Roth conversions. What are your thoughts on LIRP versus mega backdoor Roth?

Answer: Mega backdoor Roths are such a sweet deal for higher-income workers that you probably should take advantage if you want to put aside more tax-advantaged money for retirement.

For those who are unfamiliar: Roth IRAs allow tax-free withdrawals in retirement, but only people with incomes under certain limits can contribute directly to a Roth. The ability to contribute phases out for married couples filing jointly with modified adjusted gross incomes of $204,000 to $214,000.

There’s no income limit on conversions, however, so people with higher incomes can contribute to a traditional IRA and then convert the contribution to a Roth IRA in what’s known as a backdoor Roth. Conversions typically trigger income taxes on any pretax contributions or earnings, so this tactic works best if the person doesn’t have a large existing IRA.

The mega backdoor Roth takes this strategy to a new level.

Some employer 401(k) plans allow participants to make after-tax contributions that can then be converted to a Roth. The amounts that can be contributed and converted are substantial. Although the pretax limit for contributions is $20,500 for workers under 50 in 2022, the total amount that can be contributed by employees and employers to a 401(k) is $61,000.

The amount you can put in after tax would be reduced by any company match you get. Assuming there’s no match, you could contribute $20,500 to the pretax plan and an additional $40,500 to the after-tax plan this year.

A mega backdoor Roth would allow you to build up a substantial fund of tax-free retirement money without the costs and other potential disadvantages of a LIRP, which requires you to buy a permanent life insurance policy. With a LIRP, you would use the cash value of the policy to hold investments that you could access tax free through withdrawals or loans.

LIRPs can make sense if you otherwise need permanent life insurance, but many people need only term insurance, which is much less expensive.

If you’re still interested in a LIRP, consult with a fee-only, fiduciary financial advisor first to ensure you understand how these work and determine if they’re a good solution for you.

Q&A: Social Security divorced spouse benefits

Dear Liz: You recently answered a woman about collecting on her ex-husband’s Social Security record. You said she was eligible for a spousal benefit if they were married at least 10 years, which they were. I think you should have added that the spouse needs to be collecting their own Social Security when you apply. A Social Security rep told me I had to wait till my ex retired and then I’d automatically get the larger benefit. I waited. Eventually I asked my ex and he said he had started collecting Social Security some months previously. I applied and did get a retroactive payment.

Answer: Unfortunately, people don’t always get correct information from Social Security representatives.

You did not have to wait for your ex to begin receiving Social Security to apply for a divorced spousal benefit. While that’s a requirement for still-married couples — the primary worker must apply for their own benefit to trigger a spousal benefit — a divorced spouse has only to wait until their ex turns 62 and is eligible to receive Social Security retirement checks.

The representative you talked to may not have understood that you were talking about an ex rather than a current husband, or the rep may have been confused about the rules.

Because Social Security can be so complicated, it makes sense to educate yourself as much as possible about the rules. Books like Jonathan Peterson’s “Social Security for Dummies” can be helpful; just make sure to get the latest edition, since the rules for spousal benefits changed substantially in 2015.

Q&A: You need to satisfy this key requirement to get an IRS home sale tax exemption

Dear Liz: I was given a condominium, which I’m renting out while I live overseas, traveling from country to country. I understand that when I sell the condo, I can exclude up to $250,000 of home sale profits if the property is my “primary residence” for at least two of the last five years. But how is primary residence established? I have heard that the IRS looks at the address on your tax returns, on your voting registration and on file with the Department of Motor Vehicles. I list the condo’s address for voter registration but with the IRS and DMV, I use my mail forwarding address. Will that keep me from establishing the condo as my primary residence?

Answer: What’s keeping you from establishing the condo as your primary residence is the fact that it’s not your primary residence. Someone else is living there and paying you rent.

If you want to take advantage of the home sales profit exemption, you need to actually occupy the home. You’re allowed “short, temporary absences” but not the vagabond life.

Q&A: Avoiding Medicare late enrollment penalties

Dear Liz: I have taken multiple in-person and online educational classes about Medicare prior to my 65th birthday. What I learned from these classes was that the law demands people register for Medicare Part A when we turn 65 whether we are working or not. Like the woman in your column, I also work full time and do not plan to retire until 70 (at least that is my new target date). At the time of my retirement I will apply for Medicare Part B and purchase supplemental insurance.

Answer: It’s wonderful that you made the effort to educate yourself about Medicare, which can be incredibly complicated. However, you got the wrong lesson about what’s required, since there’s no law that forces people to sign up for any part of Medicare, including Part A, which covers hospitalizations and which is typically premium-free.

The reason most people should sign up at age 65 has to do with penalties. People who delay signing up for Medicare Part B, which covers doctor’s visits, or Part D, which covers prescriptions, can face permanent, lifetime premium penalties unless they qualify for certain exemptions. One of those exemptions is having qualifying health insurance coverage from a job, either your own or your spouse’s. You can find more details at https://www.medicare.gov/basics/costs/medicare-costs/avoid-penalties.

Q&A: Dealing with credit challenges

Dear Liz: I felt you should have corrected the person who said they felt like a loser because heavy credit card usage lowered their credit scores. I went through a period of poor credit after I was diagnosed with amyotrophic lateral sclerosis (ALS). It took about nine months to get our financial footing again. My scores are on the mend now, but at no point did I feel like a loser. In fact, I am very proud of how I and my family responded to this challenge. Many people are hit with misfortune that is no fault of their own. Often they are truly winners with how they respond. I hope you take the opportunity to make a comment about how bad credit doesn’t make a person a loser. That often the best of us are revealed by how we deal with it instead.

Answer: The original letter writer was making a wry comment about their situation, writing that their husband “thinks it’s funny he has great scores and I look like a loser!”

But your point about people being more than their credit scores is well taken.

Q&A: Delaying Social Security benefits

Dear Liz: I reached my full Social Security age (66) in December 2020. I’ve been waiting until age 70 to start benefits so I can get the 8% annual delayed retirement credits and maximize my benefit. However, if the 2023 cost of living increase will be 10.5%, should I go ahead and start benefits this year, at age 68? Does someone need to be on Social Security for a full year before being eligible for the COLA, or would one month be enough?

Answer: Your benefit will get the cost of living increase whether you’ve started receiving checks or not. In fact, it’s been getting those increases since you turned 62 and became eligible. So applying now just means giving up two years’ worth of delayed retirement credits.

Q&A: Is the ‘tax torpedo’ coming for you? Here’s what you need to know

Dear Liz: I am pondering the best time to begin drawing Social Security. I have no debt, am 61, retired and fortunate enough to have retirement funds that are projected to last until I’m 95 without Social Security. That said, when I begin drawing Social Security, I understand I am likely to get taxed at the full 85% rate based upon the monthly income I receive. Does it make sense to hold off on applying until 67 or later knowing that I’ll be taxed more on the higher income, or should I draw sooner, understanding the tax liability would be less? Or, when I begin receiving Social Security, would I cut back on the amount of retirement funds I receive monthly?

Answer: The way Social Security benefits are taxed is somewhat convoluted and easy to misunderstand. Just to be clear: You would never lose 85% of your Social Security benefit to taxes. But if you have income outside of Social Security, up to 85% of your benefit can be taxable at your regular income tax rates.

The taxes are based on what’s known as your “combined income,” which is your adjusted gross income plus any nontaxable interest plus half of your Social Security benefits. If you’re single and your combined income is between $25,000 and $34,000, up to 50% of your benefits may be taxable. If your combined income exceeds $34,000, you may owe tax on up to 85% of your benefits.

If you’re married filing jointly, combined income between $32,000 and $44,000 could trigger taxes on up to 50% of your benefit. If your combined income is more than $44,000, up to 85% of your benefit may be taxable.

Because of this unusual structure, people can face what’s known as a tax torpedo, which is a sharp rise and then fall in their marginal tax rates. If your income is high enough, you won’t be able to avoid the tax torpedo.

However, many middle-income people can mitigate its effects by delaying Social Security and drawing down their retirement funds instead. You can get some understanding of how this works by searching on the phrase “tax torpedo.”

For a more in-depth analysis, search for the research paper by William Reichenstein and William Meyer titled “Understanding the Tax Torpedo and Its Implications for Various Retirees.”

Consider discussing your situation with a fee-only financial planner who can model different scenarios and give you personalized advice.

Q&A: Wait to draw Social Security

Dear Liz: I’m about to turn 75. My wife is 67. I started collecting Social Security at age 70. My benefit is on the low side but I also get a union monthly pension. My wife is still working and planning to file for her Social Security benefit at 70, and she may get three times my amount. Is there a provision where I could be collecting a higher amount now based on her earnings?

Answer: Your wife would have to apply for her benefit before you would be eligible for a spousal benefit based on her work record. Once she applies, your spousal benefit would be 50% of her “primary insurance amount” — which is the benefit she would get at her full retirement age. For someone born in 1955, the full retirement age is 66 years and 2 months.

If she did apply now, your benefit might increase but she would miss out on the delayed retirement credits that would increase her checks by 8% for each year she puts off applying until age 70.

Generally, it’s a good idea for the person with the larger benefit to delay applying as long as possible, since it’s their check that determines what the survivor gets. But there are always exceptions, so you’d be smart to research your options. Social Security Solutions and Maximize My Social Security can help you model different claiming strategies, or you could discuss your situation with a financial planner.

Q&A: Medicare Part A

Dear Liz: You recently answered a question from someone who was delaying signing up for Medicare because he had health insurance through his job. You mentioned that if the employer had 20 or more employees, he didn’t have to sign up until that employment ended. That’s correct, but there’s typically no cost for Medicare Part A so there’s no reason not to sign up.

Answer: That’s an excellent point. Medicare Part A covers hospital visits and typically is premium-free, so signing up at age 65 is a good idea even if you have insurance coverage through work. The other parts of Medicare require monthly premiums and can impose penalties if you don’t apply when you’re first eligible.

Q&A: Switching back to original Medicare

Dear Liz: I’m 75 and I’ve been on an Advantage plan since I started on Medicare at 65. I’m interested in switching to original Medicare with a supplemental policy. I know I will have to enroll in a drug policy also. Will I be subject to any penalties for late enrollment for any of the three policies?

Answer: You won’t be subject to penalties but you will be subject to underwriting for the supplemental policy. That means the private insurance companies that offer these plans can deny you coverage or charge you more for preexisting conditions.

There are a few exceptions. Insurers can’t subject you to underwriting if you’re still within the first 12 months of having a Medicare Advantage plan, for example, or if you move out of the plan’s service area. In addition, four states — Connecticut, Maine, Massachusetts and New York — require Medigap companies to offer coverage to all Medicare beneficiaries.

Start shopping around and make sure your application for a supplemental policy has been approved before canceling your current plan.