One of the biggest problems for high net worth individuals (HNWI) is a heavy concentration of savings in tax-deferred retirement accounts, specifically pre-tax traditional 401(k) and IRA accounts. While the tax deduction on a contribution to a 401(k) can provide benefits during your peak earning years, if too much is saved in pre-tax accounts, it can lead to problems in retirement.
Required Minimum Distribution Tax Bomb
The tax deduction you get for saving in a pre-tax account is simply the result of deferring taxation of income until you begin taking withdrawals from your accounts. If you defer too much, eventually it can create a tax bomb in the form of excessive RMDs. The required minimum distribution (RMD) tax bomb occurs when the distributions you're required to take exceed what you actually need to cover expenses in retirement.
Here are a few of the negative impacts of these excessive withdrawals:
- The extra income you're forced to take creates a domino effect. It increases your overall taxable income, which could increase your marginal tax rate and ultimately your capital gains tax rate. In addition, it could lead to higher Medicare premiums and a larger percentage of your Social Security income being taxable.
- It forces you to halt tax-deferred growth by selling investments that are compounding without any tax drag.
- It leaves you with the decision to either spend the money (when you didn't need it in the first place) or invest it in a less tax-efficient account (such as a taxable brokerage account). (For related reading, see: Strategic Ways to Distribute Your RMD.)
Account Type Diversification
Since pre-tax retirement accounts are the only accounts subject to RMDs, this problem can be avoided by diversifying your savings into different account types. More specifically, you can diversify into three different buckets: Pre-tax retirement accounts, after-tax retirement accounts (Roth IRAs), and taxable accounts.
The amount of savings you allocate to each of these three account types depends on your unique situation, but in most cases, it's beneficial to have some type of allocation to all three. However, some high-income earners ignore the after-tax Roth accounts for these reasons:
- They are saving for retirement under the false assumption that since they are in a high-tax bracket now, they should only save in pre-tax accounts. (For related reading from the author, see: How to Decide Between a Traditional or Roth 401(k).)
- They don't have access to a Roth 401(k) and make too much money to contribute to a Roth IRA.
The second scenario is more common than the first. High-income earners don't have access to an employer-sponsored Roth 401(k), they make too much money to contribute directly to a Roth IRA, or both.
In 2018, to make a full contribution to a Roth IRA, your modified adjusted gross income (MAGI) must be less than $189,000 if you file married filing jointly. If you file individually, the limit is $120,000.
Since high-income earners usually make above these limits, they are right in assuming they're not allowed to make direct contributions to a Roth IRA. However, they may be eligible to contribute indirectly through a backdoor Roth IRA.
How to Complete a Backdoor Roth IRA Contribution
The strategy is simple, widely-used and pretty easy to understand if you follow these three steps:
- Make a maximum contribution to a traditional IRA ($5,500 if <50 years old, $6,500 if >50 years old). The contribution you make will be a non-deductible contribution. Since you’re over the income limits to deduct the contribution, you can withdraw it or convert it tax- and penalty-free at any time. Make sure to not invest this contribution and to keep it in cash.
- Convert the non-deductible traditional IRA contribution to your Roth IRA. In 2010, Congress removed the income limits stipulating who could perform a Roth IRA conversion. Since you’re converting a non-deductible traditional IRA to a Roth IRA, no taxes are due and you’ve effectively made a maximum contribution to your Roth IRA. At this point you can invest the funds and all the subsequent growth is tax-free (assuming you make qualified withdrawals).
- Fill out form 8606 when you file your taxes. It tracks your non-deductible contributions, distributions and conversions. It’s imperative to fill out this form correctly so you don’t accidentally pay taxes on the conversion. Whether you fill it out yourself, do it in Turbo Tax or hire a professional, the end result should be $0 on Line 18: Taxable Amount.
There are two problems that may arise while you are trying to complete a backdoor Roth IRA contribution.
IRA Aggregation Rule
When you convert money from a traditional IRA to a Roth IRA, the IRS aggregates the balances of all your IRAs (traditional, SIMPLE, and SEP) to determine what percentage of your aggregate balance is pre-tax and what percentage is not. Then they pro-rate the taxable portion of the Roth conversion based on that amount.
For example, assume you have a traditional IRA with a balance of $50,000 funded entirely with deductible contributions. This year you decide you want to do a backdoor Roth IRA contribution, so you make a non-deductible $5,500 contribution to the IRA, bringing the total balance to $55,500. As a result, 90% of the IRA is pre-tax ($50,000 out of $55,500) while only 10% is after-tax ($5,500 out of $55,500). When you convert your $5,500 from your traditional IRA to your Roth IRA, 90% of the conversion will be taxable, which turns out to be $4,950. The remaining 10%, $550 will be a tax-free conversion.
In this case, the entire purpose of a backdoor Roth IRA contribution is defeated since the majority of the conversion becomes taxable. Fortunately, there is a way around this. If you want to do a Backdoor Roth IRA but you have money saved in pre-tax IRAs, you can explore doing a reverse rollover, which potentially allows you to “hide” the pre-tax IRA within a 401(k) account.
Step Transaction Doctrine
The step transaction doctrine basically says a series of related steps in a transaction should be taxed based on the overall nature of the transaction. In the case of backdoor Roth IRA contributions, the step transaction doctrine could apply since the purpose of contributing to a non-deductible IRA and converting it to a Roth IRA is to get around the income limits on who can contribute to a Roth IRA. Since the backdoor Roth IRA contribution strategy began in 2010, the conversion from a non-deductible IRA to a Roth has never been disallowed due to the step transaction doctrine. However, that doesn't mean it couldn't apply in the future. (For related reading, see: The Pros and Cons of Creating a Backdoor Roth IRA.)
The Bottom Line
If you are a high-income earner and have a large concentration in pre-tax earnings, backdoor Roth IRA contributions are a great way to begin saving in a Roth account. The diversification of account types allows you flexibility to control your taxes in retirement and extend the longevity of the retirement capital you’ve saved.
(For more from this author, see: How Timing Impacts Your Retirement Portfolio Longevity.)