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Roth IRA

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

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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: How your health insurance costs could rise because of a Roth IRA conversion

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Dear Liz: With the recent stock market correction, I am considering doing a Roth conversion on an existing IRA now that it is worth less. I can handle the accompanying income tax hit. But while I see plenty of ink spilled on how a Roth conversion can increase Medicare premiums, what about Affordable Care Act costs? Is it the same story there: Will a one-time income spike this year due to Roth conversion impact what I pay all next year for ACA health insurance?

Answer: Potentially, yes. Roth conversions count as income for Affordable Care Act subsidies, so a large enough transaction could increase the premiums you pay.

A conversion allows you to transfer money from a regular IRA or 401(k), which would be taxable in retirement, to a Roth IRA, which would be tax free. If you expect to be in a higher tax bracket in retirement, conversions can make sense — you’re paying income taxes at the lower rate now, rather than the higher rate later. But obviously higher health insurance premiums would offset some of that benefit.

A tax pro can help you model conversions of different sizes to see the effects on all your finances, not just your tax bill. It’s possible that a partial conversion could help you take advantage of the current downturn without dramatically increasing your health insurance costs.

Q&A: Consider taxes before retirement

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Dear Liz: I began converting two 401(k)s from previous employers to Roth IRAs. To lessen the huge tax hit, I decided to do the conversions over the course of seven years. Even with that, the tax hit is higher than I realized and too painful. Now that partial conversions have begun annually, am I required to complete the total conversion to 100%? Or can I stop midway and leave the remainder in the original accounts? Also, is there an age limit before which Roth conversions must be completed?

Answer: You don’t have to continue making conversions. (Before 2018, you could have even reversed conversions you already made, but that’s no longer possible.) There’s also no age limit for conversions, but the older you get, the less likely conversions are to make financial sense.

Conversions are a good bet if you expect to be in the same or a higher tax bracket in retirement. If you’re young and in a low tax bracket now, you can reasonably expect that to be the case.

As you approach retirement, though, the opposite may be true. Many people find their tax bracket drops once they retire. Why pay a big tax bill now if you can access the money at a lower tax rate later?

Then again, if you’re a good saver, you may discover you’ve accumulated so much that your tax bill will soar once you’re required to start taking minimum distributions at age 72. If that’s the case, then converting some of your retirement money might save you on taxes overall.

But you’ll want to discuss this with a tax pro or financial planner who can model how the conversions are likely to affect your overall finances, including any Medicare premiums, since those can increase with income.

Q&A: How to start an IRA for your new Gen Z college graduate

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Dear Liz: My son is about to graduate from college and, as a present, I want to use $10,000 to start an IRA for him. But which is better? A Roth or a standard IRA?

Answer: Congratulations to both of you! Starting a retirement account is a great idea, but you should be aware of the numerous rules that limit who can contribute and how much.

Let’s start with the annual contribution limit, which for 2022 is $6,000 for people under 50. (People 50 and older can make an additional $1,000 “catch up” contribution.) Also, your son needs to have earned income — such as wages, salary or self-employment income — that is at least equal to the size of the contribution you want to make. In other words, he needs to earn $6,000 for you to contribute $6,000. If he’s about to start a full-time job, that probably won’t be an issue, but if he’s not working, or working only part time before starting graduate school, that might further limit how much you can contribute.

For all of those reasons, a Roth IRA contribution may be best. He won’t get an upfront tax deduction but withdrawals in retirement will be tax free. He can withdraw Roth contributions at any time without taxes or penalties, so the Roth can serve as a de facto emergency fund. Obviously, it’s better to leave the money alone to grow, but having access to the cash could be helpful while he builds a regular emergency fund.

Q&A: Reducing taxes in retirement

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Dear Liz: It appears required minimum distributions will force me to take an additional $3,500 per month from my retirement funds starting in four years at age 72. This added taxable draw will greatly impact my income tax liabilities as I’m now fully retired. Are there any strategies at this time to reduce the hit? As my current income tax rate is 12% federal and 9% state, perhaps I should convert some of these funds to Roth IRAs?

Answer: Partial Roth conversions when your tax bracket is low can be an excellent way to reduce future mandatory withdrawals and save on taxes in the long run.

Let’s say you’re married filing jointly and have $60,000 in taxable income. The 12% federal tax bracket ends at $83,550, so you could convert more than $23,000 of your retirement funds without increasing your marginal federal tax rate. Conversions can affect other aspects of your taxes and finances, so consult a tax pro before proceeding.

Another way to potentially lower your tax bill may be to temporarily suspend your Social Security payments and take more from your retirement funds. Because of the peculiar way that Social Security is taxed, people often face a sharp rise and then fall in marginal tax rates when they have other income, something known as the “tax torpedo.” A tax pro should be able to determine if delaying or suspending Social Security payments could help you reduce the effects.

Monday’s need-to-know money news

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Today’s top story: What to do if your home insurer won’t renew your policy. Also in the news: A new episode of the SmartMoney podcast on job scams and maxing out a Roth IRA, how to hand mixed-income friendships, and student loan payments come back for real Feb. 1st.

What to Do If Your Home Insurer Won’t Renew Your Policy
Has a high-risk property left you without insurance coverage? You still have options.

Smart Money Podcast: Job Scams and Maxing Out a Roth IRA
How to spot job scams and how to avoid them.

How to Handle Mixed-Income Friendships
Empathy and realism are key.

Get Ready: Student Loan Payments Come Back for Real Feb. 1
Your financial situation should determine how you handle the final federal student loan extension.