By Tiffany Lam-Balfour
This article provides information and information for investors. NerdWallet does not provide advisory or brokerage services, nor does it recommend or advise investors to buy or sell certain stocks or securities.
During the campaign, President-elect Joe Biden highlighted his plans to make some changes to the current tax law.
Now that the choice has been made, some people may be wondering how his tax plans could affect them.
Biden’s plan includes tax cuts for working families and tax increases for the richest Americans who earn $ 400,000 or more per year. He suggests “asking those who earn more than $ 1 million to pay the same rate for investment income that they get on their wages”.
Promises made on the campaign path often take a different shape when a candidate takes office and sees how accessible Congress is to his ideas. However, if you are concerned about your tax burden increasing, especially with regards to your retirement savings, now is the time to consider a step.
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“For anyone who believes taxes will rise because of a candidate’s policies (or because of our debts and deficits), a Roth IRA is a great ‘tax hedge,'” said Scott Bishop, Certified Certified Financial Planner, Chartered Accountant and Executive Vice President for Financial planning at STA Wealth Management in Houston.
What you should know about Roth IRAs and conversions
A Roth IRA is a retirement account on which the money grows tax-free. You pay taxes upfront at your current income tax rate. This allows investors to increase their money and make withdrawals without federal taxes in retirement, provided they have held the Roth IRA for over five years and withdraw after the age of 59 ½ years. The Roth is an alternative to a traditional IRA, where taxes are accrued and paid on retirement withdrawals.
Roth IRAs can be attractive for investors who expect taxes to rise or be in a higher tax bracket in the future. Qualified withdrawals of investment income within a Roth IRA are not subject to investment income tax upon sale. And unlike traditional IRAs or 401 (k) s, no minimum payouts or RMDs are required, giving investors more flexibility in deciding when and how much to withdraw from their Roth IRA account.
What’s the catch? You cannot open or contribute to a Roth IRA if your Modified Adjusted Gross Income in 2020 is greater than $ 139,000 ($ 140,000 in 2021) for single applicants and $ 206,000 in 2020 ($ 208,000 in 2021) if you are married and submit together. However, there is another way.
Enter the Roth IRA back door. It’s not a separate type of IRA, it’s a workaround – a legal one! – by which higher earners can circumvent these income limits. First, you make a non-deductible contribution to a traditional IRA, and then you convert that contribution to a Roth IRA shortly thereafter. The annual contribution limit for a Roth IRA is $ 6,000 ($ 7,000 if you are over 50). If you shoot through the back door every year, over time you may be able to build a tax-free nest egg for retirement and enjoy the unique benefits of the Roth IRA.
While the term “back door” only refers to this high-income workaround, you can do what is known as a Roth IRA conversion if you have saved to a traditional IRA but believe that a Roth IRA is best. Although you are experiencing a tax break now, it could be less than the tax burden you would face in the future.
Precautions for thought
Bishop said one limitation to be aware of when running the back door Roth IRA is the proportionate rule. This rule means that at tax time, the IRS will look at all of your traditional IRA accounts together, like a large IRA rather than separate accounts, to assess what percentage of the funds converted are taxable.
Investors need to weigh the future tax benefits of a backdoor Roth against the amount of tax they would have to pay up front.
Ross Riskin, Associate Professor of Taxes at the American College of Financial Services, says, “Roth conversions are most useful when the taxpayer believes they will be in a higher tax bracket in the future.” However, before taking such a step, consider your full financial picture and possibly seek advice from a tax advisor.
The advantages of not being influenced by politics
Many taxpayers are already using backdoor Roths and Roth IRA conversions for tax breaks. Making a backdoor Roth “should be considered every year for a high income, not just an election year,” said Paul Miller, auditor at Miller & Company LLP in New York.
And that leads to a different, perhaps better way of thinking about this or any other money move: If this wasn’t an election year, would you do it anyway? Adjustments to your financial plan should serve your financial goals, not just for fear of a short-term election result.
In addition to those who expect higher taxes in the future, Riskin mentions other cases where Roth conversions might be prudent. For example, those who are subject to increased taxes on their Social Security payments after the onset of RMDs, or those who happen to have net operating losses who can offset the income tax bill from the conversion.
“It is very important to keep in mind that taxes are likely to increase in the future, but we are unsure which taxes will increase and that this may affect the decision to convert pension funds now,” says Riskin.
“Of course, when income taxes rise, Roth conversions make more sense,” he says. “But what if sales tax goes up? What if real estate and property taxes go up? What if a sales tax is introduced as it is a popular way to increase revenue in most other countries? These types of tax increases are definitely possible and are being considered. All of this has no direct impact on whether or not a taxpayer converts their pre-tax retirement accounts to Roth after-tax accounts. “
In other words, while predicting the future is tempting, your current financial plan could still make sense to you, despite possible changes in tax law.
This article was reprinted with permission from NerdWallet.
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Tiffany Lam-Balfour writes for NerdWallet. Email: tlambalfour@nerdwallet.com.