By Tiffany Lam-Balfour
This article provides information and education for investors. NerdWallet does not offer advisory or brokerage services, nor does it recommend or advise investors to buy or sell particular stocks or securities.
While campaigning, President-elect Joe Biden highlighted his plans to make some revisions to the current tax code.
Now that the election has been decided, some people might be wondering how his tax plans might affect them.
Biden’s plan includes tax cuts for working families and tax increases on the wealthiest Americans, those earning $400,000 or more per year. He proposes “asking those making more than $1 million to pay the same rate on investment income that they do on their wages.”
Promises made on the campaign trail often take a different shape once a candidate takes office and sees how amenable Congress is to his ideas. But if you’re worried about your tax bill climbing higher, specifically around your retirement savings, there’s a step you can consider taking now.
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“For anyone that believes taxes will go up because of a candidate’s policies (or that it will happen due to our debts and deficits), a Roth IRA is a great ‘tax hedge,’” said Scott Bishop, a certified financial planner, certified public accountant and executive vice president of financial planning at STA Wealth Management in Houston.
What to Know About Roth IRAs and Conversions
A Roth IRA is a retirement savings account in which money grows tax-free. You pay taxes upfront, at your current income tax rate. This allows investors to grow their money and take withdrawals free from federal taxes in retirement, so long as they’ve held the Roth IRA for over five years and withdraw after age 59 ½. The Roth is an alternative to a traditional IRA, where taxes are deferred and paid on withdrawals in retirement.
For investors who expect taxes to go up or that they’ll be in a higher tax bracket in the future, Roth IRAs can be attractive. Qualified withdrawals of investment earnings within a Roth IRA are not subject to capital gains tax when sold. And unlike traditional IRAs or 401(k)s, there are no required minimum distributions, or RMDs, so investors also have enhanced 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 is greater than $139,000 in 2020 ($140,000 in 2021) for single filers and $206,000 in 2020 ($208,000 in 2021) if married and filing jointly. However, there is another way in.
Enter the backdoor Roth IRA. It’s not its own type of IRA, but rather a workaround — a legal one! — by which higher earners can circumvent those income limits. First, you make a nondeductible contribution to a traditional IRA, and then you convert that contribution into a Roth IRA shortly thereafter. The annual contribution limit for a Roth IRA is $6,000 ($7,000 if you’re age 50-plus). By scooting through the back door every year, you can potentially build up a tax-free retirement nest egg over time and enjoy the Roth IRA’s unique benefits.
While the “backdoor” designation refers only to this workaround for high earners, if you’ve been saving into a traditional IRA but think a Roth IRA would suit best, you can do what’s called a Roth IRA conversion. Though you’ll take a tax hit now, it could be less than the tax bill you’d have faced in the future.
Caveats to Think About
Bishop said one caveat to be aware of when executing the backdoor Roth IRA is the pro rata rule. This rule means that at tax time, the IRS will look at all of your traditional IRA accounts combined, like one large IRA rather than separate accounts, to evaluate what percentage of funds converted will be taxable.
Investors will need to weigh the future tax benefits of a backdoor Roth against the amount in taxes they’d need to fork over upfront.
Ross Riskin, an associate professor of taxation at The American College of Financial Services, says that “Roth conversions make the most sense in cases where the taxpayer believes they will be in a higher tax bracket in the future.” But before you make such a move, consider your full financial picture and perhaps consult with a tax advisor.
The Merits of Not Letting Politics Sway You
Many taxpayers already use backdoor Roths and Roth IRA conversions for the tax break. Doing a backdoor Roth “should be considered during any year for a high-income earner, not just in an election year,” says Paul Miller, a certified public accountant at Miller & Company LLP in New York.
And that gets at another, perhaps better way to think about this or any other money move: If this weren’t an election year, would you still do it? Making adjustments to your financial plan ought to be in service of your financial goals, not simply out of fear of a near-term election result.
Besides those expecting higher taxes in the future, Riskin mentions other instances where Roth conversions might be prudent. For instance, for those subject to increased taxes on their Social Security payments once RMDs kick in, or those who happen to have net operating losses that can balance out the income tax bill from conversion.
“It is very important to keep in mind that while taxes will likely increase in the future, we do not know for sure which taxes will increase, and that can affect the decision to convert retirement funds now,” Riskin says.
“Obviously, if income taxes increase, Roth conversions may make more sense,” he says. “But what if sales taxes increase? What if real estate and property taxes increase? What if a value-added tax is put in place, as this is a popular way of raising revenue in most other countries? These types of tax increases are definitely possible and being considered, all of which will have no direct impact on whether a taxpayer chooses to convert their pretax retirement accounts into after-tax Roth accounts or not.”
In other words, while it’s tempting to predict the future, your current financial plan might still make sense for you despite any potential changes in tax law.
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Tiffany Lam-Balfour writes for NerdWallet. Email: email@example.com.