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Converting a Traditional IRA to a Roth IRA at a Young Age: What Should Jack Do?

Drew Deimel

02/10/2021

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
Age

Trad
– IRA

Contribution
(Annually)

Average
Return

Periods

Future
Value

30

$45,000

$6,000

6%

35
Years

$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
Age

Trad
– IRA

Roth
IRA

Contribution
(Annually)

Average
Return

Periods

Future
Value

30

0

$45,000

$6,000

6%

35
Years

$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

The information included in this document is for general, informational purposes only. It does not contain any investment advice and does not address any individual facts and circumstances. As such, it cannot be relied on as providing any investment advice. If you would like investment advice regarding your specific facts and circumstances, please contact a qualified financial advisor.

Any investment involves some degree of risk, and different types of investments involve varying degrees of risk, including loss of principal. It should not be assumed that future performance of any specific investment, strategy or allocation (including those recommended by HBKS® Wealth Advisors) will be profitable or equal the corresponding indicated or intended results or performance level(s). Past performance of any security, indices, strategy or allocation may not be indicative of future results.

The historical and current information as to rules, laws, guidelines or benefits contained in this document is a summary of information obtained from or prepared by other sources. It has not been independently verified, but was obtained from sources believed to be reliable. HBKS® Wealth Advisors does not guarantee the accuracy of this information and does not assume liability for any errors in information obtained from or prepared by these other sources.

HBKS® Wealth Advisors is not a legal or accounting firm, and does not render legal, accounting or tax advice. You should contact an attorney or CPA if you wish to receive legal, accounting or tax advice.


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