Backdoor Roth Conversion: $87,000 Tax Savings for High-Income Earner

Backdoor Roth Conversion: $87,000 Tax Savings for High-Income Earner

Executive Summary

Our client, a high-earning professional in California, was ineligible for direct Roth IRA contributions due to income limitations, hindering their ability to build tax-advantaged retirement savings. We implemented a Backdoor Roth conversion strategy, converting non-deductible traditional IRA contributions into a Roth IRA, bypassing these income restrictions. This strategic approach resulted in a projected $87,000 in tax savings over the client's retirement horizon, significantly enhancing their after-tax retirement income.

The Challenge

Our client, a 48-year-old software engineer earning $285,000 annually, approached us seeking to optimize their retirement savings strategy. Due to their high income, they exceeded the IRS income limits for directly contributing to a Roth IRA. For the 2023 tax year, the Roth IRA contribution limit was phased out for single filers with modified adjusted gross income (MAGI) between $138,000 and $153,000, completely eliminating direct contribution eligibility above $153,000.

This limitation meant that our client's traditional retirement contributions to their 401(k) were the only tax-advantaged option available. While the 401(k) offered pre-tax contributions and tax-deferred growth, all withdrawals in retirement would be taxed as ordinary income. This posed a significant concern, as projections indicated they would likely be in a similar or higher tax bracket during retirement.

Furthermore, our client had accumulated approximately $30,000 in a traditional IRA account from previous employer-sponsored plan rollovers. This account presented a potential tax liability during retirement withdrawals, and it also complicated any potential attempt at Backdoor Roth conversions due to the pro-rata rule.

The client’s primary concerns were:

• Limited Tax-Advantaged Savings: Inability to directly contribute to a Roth IRA.
• High Future Tax Liability: Concerns about paying high taxes on traditional retirement account withdrawals in retirement.
• IRA Pro-Rata Rule: Existing traditional IRA balance hindering the effectiveness of Backdoor Roth conversions.
• Missed Growth Opportunity: Losing out on potential tax-free growth within a Roth IRA.

The Approach

To address these challenges, we implemented a multi-pronged strategy focused on maximizing Roth IRA contributions and mitigating future tax liabilities:

1. Backdoor Roth Conversion Strategy: We recommended utilizing the Backdoor Roth conversion strategy, which involves making non-deductible contributions to a traditional IRA and then immediately converting those contributions to a Roth IRA. This circumvents the income limitations for direct Roth IRA contributions.

2. Traditional IRA Rollover (Optional): To mitigate the impact of the pro-rata rule (where conversion taxes are calculated based on the ratio of pre-tax IRA assets to after-tax IRA assets), we explored rolling over the existing $30,000 traditional IRA balance into their current 401(k). This would leave only the non-deductible contributions in the traditional IRA, minimizing the tax liability upon conversion. This was optional since the taxes on the Roth conversion could be manageable based on a conservative estimate.

3. Annual Roth Conversion Optimization: We planned to make annual non-deductible contributions to a traditional IRA, followed by immediate Roth conversions. We would then use tax planning software to carefully model the impact of each conversion on the client's overall tax situation, optimizing the conversion amount to minimize the tax liability in the conversion year while maximizing the amount converted to Roth.

4. Long-Term Tax Projections: Using RightCapital, we modeled the client's retirement income, tax brackets, and potential tax liabilities under various scenarios, including continued traditional retirement savings versus incorporating Backdoor Roth conversions. This helped us quantify the potential tax savings and demonstrate the long-term benefits of the strategy.

Our decision framework prioritized:

• Tax Efficiency: Minimizing taxes both in the conversion year and throughout retirement.
• Simplicity: Implementing a straightforward process that the client could easily understand and maintain.
• Compliance: Ensuring all contributions and conversions complied with IRS regulations.
• Long-Term Growth: Maximizing the potential for tax-free growth within the Roth IRA.

Technical Implementation

The technical implementation involved careful planning and execution using specific financial tools and methodologies:

1. Non-Deductible Contribution: The client made a $6,500 non-deductible contribution to a traditional IRA. Since he was under 50, this was the maximum contribution allowed for the 2023 tax year.

2. Immediate Roth Conversion: We then initiated a Roth conversion of the $6,500 non-deductible contribution. Because the amount was immediately converted, there was minimal or no earnings to be taxed.

3. Pro-Rata Rule Calculation: Because the client had existing funds in a Traditional IRA, we calculated the tax implications. In this case, the client decided to leave the funds in the Traditional IRA and pay the associated taxes. The pro-rata rule considers all of your IRA assets to determine what portion of your Roth IRA conversion is taxable.

   The formula for the taxable amount is:

   (After-tax contributions / Total IRA balance) * Conversion amount

   In our client's case, they had $6,500 of after-tax funds, $30,000 of pretax funds, and a conversion amount of $6,500.

   ($6,500 / ($6,500 + $30,000)) * $6,500 = $1,150 taxable amount

4. RightCapital Modeling: We utilized RightCapital to model the client's long-term retirement income and tax liability. We created two scenarios:

   • Scenario 1: Baseline: Continued contributing to their 401(k) only, with no Roth conversions.
   • Scenario 2: Backdoor Roth Conversion: Annual non-deductible IRA contributions and immediate Roth conversions, following the projections for tax rates and brackets over time.

   RightCapital allowed us to project the client's marginal tax rates in retirement, estimate the tax impact of the Roth conversions in the conversion year, and quantify the overall tax savings over the retirement horizon. We assumed a 7% average annual investment return and a 2% average annual inflation rate for our projections.

5. Tax Form Documentation: We provided the client with clear instructions on how to document the non-deductible IRA contributions and Roth conversions on IRS Form 8606, "Nondeductible IRAs." This ensured accurate reporting and compliance with IRS regulations.

Results & ROI

The Backdoor Roth conversion strategy yielded significant tax savings for the client:

• Projected Tax Savings: RightCapital projections showed that the Backdoor Roth conversion strategy resulted in a projected $87,000 in tax savings over the client's estimated 30-year retirement horizon (starting at age 65).
• Increased After-Tax Retirement Income: The increased tax savings translated to a higher after-tax retirement income, allowing the client to maintain a higher standard of living in retirement.
• Tax Diversification: By diversifying retirement savings across both pre-tax (401(k)) and after-tax (Roth IRA) accounts, the client gained greater flexibility in managing their retirement income and tax liability.
• Annual Conversion Amount Optimization: By carefully modeling the tax impact of each conversion, we were able to optimize the annual conversion amount to minimize the tax liability in the conversion year while maximizing the amount converted to Roth.
• Portfolio Growth: Continued, consistent contributions allowed for larger growth of tax-advantaged retirement funds.
• Peace of Mind: The client expressed a higher level of confidence in their retirement plan knowing they were taking proactive steps to minimize their future tax burden.

Specifically, the RightCapital projections showed that in retirement, without the Roth Conversions, the client would pay an estimated average effective tax rate of 22% on their retirement income. With the Roth Conversions, the effective tax rate was projected to be reduced to 19%, resulting in the $87,000 in tax savings.

Key Takeaways

Here are some key takeaways for other financial advisors:

1. Consider Backdoor Roth Conversions for High-Income Clients: Don't overlook the Backdoor Roth conversion strategy for high-income clients who are ineligible for direct Roth IRA contributions. It can be a powerful tool for maximizing tax-advantaged retirement savings.

2. Address the Pro-Rata Rule: Carefully assess the client's existing traditional IRA balances and consider strategies to mitigate the impact of the pro-rata rule, such as rolling over the traditional IRA into a 401(k).

3. Utilize Financial Planning Software: Leverage financial planning software like RightCapital to model the long-term impact of Roth conversions and optimize the annual conversion amount.

4. Provide Clear Communication and Documentation: Clearly communicate the strategy to the client and provide detailed instructions on how to document the non-deductible IRA contributions and Roth conversions on IRS Form 8606.

5. Tax Diversification is Important: Diversifying retirement savings across both pre-tax and after-tax accounts can provide greater flexibility in managing retirement income and tax liability.

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