First, let’s clear the misconception about a ROTH IRA.
If you do a ROTH Conversion this year, it will cost you money. However, in the long turn it might be the best tax avoidance strategy you could have.
Why on earth would I recommend paying higher taxes?
Let me explain. Let’s say you’ve been stuffing money away in your 401(k) plan at work. These contributions are tax-deductible, meaning every dollar you put in is subtracted from your income when calculating taxes. A great way to invest and save money on taxes. But when you start to draw money out of that 401(k) when you retire, you’re going to pay income tax on those distributions.
A Roth 401(k), on the other hand, is contributed to with after tax dollars, but then grows tax free. This means you don’t get the tax deduction now, but when you start to draw the money at retirement, it’s all tax free.
Let’s look at an example: You have $50,000 sitting in your 401(k).
Option 1: Don’t convert to Roth. If you were to leave this alone (no more contributions) and not touch it until retirement, let’s say it grows to $200,000 at retirement. At retirement you’re in the 25% bracket, you would owe roughly $50,000 in taxes (25% of $200,000).
Option 2: Convert to a Roth. You will have to pay income taxes on the converted amount at the time of conversion. So in the year you convert, assuming you’re in the 25% tax bracket, you’d have to pay $12,500. But at retirement time, the $50,000 will have grown to $200,000. On which you have no taxes due.
The Result: Option 2 saves $37,500 in taxes.
This is a simplified example and this scenario won’t work for everybody. But if you have a long time horizon before retirement, and you expect be in a similar or higher tax bracket at retirement than you are now, this can be a valuable tax saving strategy.
Still working and can’t ROTH your 401(k) or maxed out your 401(k)?
Many people make too much money to contribute to Roth IRAs, but here’s a way to sneak in the back door anyway.
How about a Backdoor Roth? Why the backdoor?
The front door for Roth’s is out of order for single people earning more than $131,000 and for married people making more than $193,000.
However, there is a simple detour to get in through the backdoor. Put money in a traditional IRA, then immediately convert it into a Roth IRA, getting all the benefits of the Roth. Better get it done now, before another loophole gets closed by President Executive Order.
While most loopholes have some caveats (and this one is no exception), this strategy has been gaining a lot of popularity.
If you have no other IRAs, it’s simple and straightforward. If you have other IRAs, it will be a bit more complicated to calculate your tax bill that year because of some of the IRS rules governing conversions.
Regardless, the Backdoor Roth is well worth investigation to sneak your way into tax free income at retirement.
Just like sneaking in to your friend’s house for the first time when you were 12, you are going to need a guide to get you in and make sure you don’t stumble or fall sneaking through the backdoor and saving for your future.
One of the ways we help our clients is by working hard to provide tax-smart investment strategies to minimize the impact Uncle Sam can have on your bottom line. We also consider it our responsibility to educate you about things that could affect your financial future. If you have any questions about your taxes or how tax-efficient planning can help reduce your tax burden, please give us call. We also recommend that you speak with a qualified tax professional who can advise you on the specifics of your personal tax situation.
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