As a high-earning professional, you’re likely paying a lot in taxes, probably in the neighborhood of 35 to 37% of your earned income. And you’re probably being prudent about your retirement savings, too, maxing out your annual contributions to your 401K and your other pre-tax retirement accounts. But if that’s the extent of your retirement planning, you’re setting yourself up to pay a high rate of taxes every year of your life, from now until well into retirement.
401Ks, 403Bs, 457s, cash balance plans, and traditional IRAs are all pre-tax accounts. So, while your contributions are tax-deferred, distributions coming out will be taxed as ordinary income. And if you’ve built up large pre-tax retirement accounts, when you turn 72 and RMDs start flowing out, the size of those RMDs will likely be large enough to keep you in the same high marginal tax bracket you’re in right now. That means your retirement income will be subject to the same high tax rates you’re paying today.
Keep saving, but start tax planning
Maxing out your retirement account contributions is definitely the right thing to be doing, but it’s not always the best long-term tax plan. While your retirement accounts will be well funded, and able to grow tax-deferred, they will not grow tax-free. If you leave your money in pre-tax accounts, you’ll be diminishing your long-term after-tax cash value significantly. In many cases, syphoning off hundreds of thousands in taxes.
Backdoor Roth IRA strategy
A pre-retirement strategy for those who are still working and have maxed out their 401K contributions is a backdoor Roth IRA. There are limits for contributions to a traditional IRA, so a high-earning professional could open a traditional IRA with pre-tax funds from savings, an individual brokerage account or a 401K conversion, pay the income and/or capital gains required upon withdrawal, and then move the post-tax funds to a Roth. They could then make annual post-tax contributions of $6,000 a year to their Roth, or $12,000 a year total if they duplicate the strategy for their spouse. Once the account holders turn 50, they can each contribute $7,000 a year when the catch-up kicks in. And if your employer offers a post-tax 401K option, you can employ a mega backdoor Roth strategy, which would allow you to contribute up to $40,500 a year to your Roth.
Roth IRA conversion strategy
Let’s say that you want to retire at 65. When you retire, you’ll stop receiving your paycheck, and your earned income will drop to zero. To prepare for this scenario, it’s recommended that while you’re still working, you fund and invest an individual brokerage account. This account will provide money for your lifestyle, replacing your paycheck in retirement, and provide the funds to pay your tax bill when you convert your pre-tax retirement accounts to a Roth IRA.
Because you’ll be in a low- or zero income tax bracket each year during the gap between when you retire and when you turn 72, you can convert large portions of your pre-tax retirement accounts to an individual Roth IRA (the exact amount would be determined by your income and the marginal income tax bracket you want to stay below). You’d use your brokerage account to pay the income taxes on the money you move over to your Roth IRA, but the money that goes in will grow tax-free from that point on.
How will this deliver (massive) value?
If your retirement savings are held in tax-deferred accounts, you will be forced by the IRS to take RMDs starting at age 72. These distributions will be taxed as ordinary income, not at the more reasonable top capital gains rate of 20%. They will be taxed at whatever marginal rate your Social Security income and RMDs put you into. Currently, with an RMD of $432,000, the tax rate would be 35%. In this scenario, you would be losing over a third of your retirement savings, and what you leave behind for your beneficiaries, to taxes.
If you employ the backdoor Roth IRA strategy early, and the conversion strategy during the gap years when your income is low, you’ll pay a fraction of what you would leaving your money in pre-tax accounts, and you’ll be able to continue to grow your retirement savings tax-free. One of the other big advantages of the Roth IRA, is that you won’t pay capital gains tax on withdrawals, and there are no RMDs, so you control what’s coming out, and when.
Converting your pre-tax retirement accounts, following a structured, tax-efficient conversion schedule, can eliminate many of the tax liabilities that would otherwise grow under the surface as you head into retirement. For a high-earning professional, the benefits of paying some taxes now, and moving your assets to a post-tax account early, can result in hundreds of thousands less in taxes paid overall.
Consult with a fiduciary adviser
An integrated Roth IRA tax planning strategy can save you a significant amount in taxes, but it must be executed carefully, and within the context of your overall financial plan. If you’d like to discuss how a Roth conversion or backdoor strategy could support your plan, schedule a consultation with one of our fiduciary advisers, at no cost or obligation. We’d be happy to answer any questions you have and to talk through your options.