First, let’s understand the difference or distinction between the two types of individual retirement accounts (IRAs).
A Traditional IRA: The account owner makes pre-tax contributions and the investments in the account grow tax-deferred, meaning that in retirement, the owner pays income tax on withdrawals.
A Roth IRA: The account owner pays taxes on money going into the account, and all future withdrawals are tax-free:
| 2021 IRA or Roth IRA contribution Limit – $6,000 |
| 2021 Catch up (above 50 years of age) – $7,000 |
I have many clients in their twenties and thirties who had prior jobs where they accumulated sizeable amounts of money in their Traditional IRAs. These clients now have high paying jobs in which they are proficient at maxing out their current work 401(k)—$19,500—and can save enough—$6,000—to also fund their IRA annually. Because their incomes are above the IRA deduction phaseout for 2021, they cannot deduct their contributions of $6,000 to a Traditional IRA:
| 2021 IRA Phaseout |
| Single – $66,000 – $76,000 |
| Married Filing Jointly – $105,000 – $125,000 |
| Non – Active Participant married to active participant $198,000 – 208,000 |
So as an independent financial advisor, how can I help these clients?
Jack: a hypothetical client
Jack is 30 years old, single, and currently earning $200,000 a year. He maxes out his employer-sponsored 401(k) at $19,500 and gets a 4 percent match from his employer. Jack puts other money aside for an overall annual savings of $42,000 a year. He has $65,000 in a bank savings account and a Traditional IRA valued at $45,000 from a previous job.
I sit down with Jack to discuss his Traditional IRA and present two options:
• Fund the IRA with that $6,000 per year, knowing he won’t realize any present-day tax benefits from that because of the income limitations on tax-deductible IRA contributions.
• Or he can convert his whole Traditional IRA to a Roth IRA, paying the taxes upfront, while adding 6,000 annually to a Traditional IRA before converting that to the Roth IRA (referred to as a back-door Roth)
My ultimate suggestion is to convert the entire $45,000 to a Roth IRA and then continue to make the annual $6,000 contribution through this back-door Roth IRA process.
If Jack keeps his money in the Traditional IRA:
|
Client |
Trad |
Contribution |
Average |
Periods |
Future |
|
30 |
$45,000 |
$6,000 |
6% |
35 |
$1,014,482 |
If Jack spends the future value over his retirement lifetime and his income tax bracket is at 20%, he will pay a total of $202,896 in taxes.
But if Jack converts the $45,000 to the back-door Roth and adds $6,000 a year:
|
Client |
Trad |
Roth |
Contribution |
Average |
Periods |
Future |
|
30 |
0 |
$45,000 |
$6,000 |
6% |
35 |
$1,014,482 |
Jack pays the tax upfront on the $45,000 at approximately 35% for a total of $15,750, then draws on the future value of $1,014,482 tax-free throughout his retirement years, an overall tax savings of $187,146.
We’re here to help. For more information about Traditional and Roth IRAs, contact HBKS Wealth Advisors at 814-459-1116, or email me at ddeimel@hbkswealth.com.
IMPORTANT DISCLOSURES
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