The market was up last week but it was a wild ride as we negotiated the fallout of SVB’s collapse. The Treasury and Federal Reserve both jumped in with support for the entire banking system. Normally, FDIC insurance covers $250,000 per account owner, but all SVB customers will have their entire account covered. We’re not worried about systemic bank failures, but it’s always smart to be aware of FDIC limits if you are holding a lot of cash.
We are doing a large number Roth IRA contributions using a strategy called the “backdoor Roth”. Remember that a traditional IRA, or Individual Retirement Account, is usually funded with pre-tax money. For example, if you made $50,000 and contributed $5,000 to a traditional IRA, you would pay taxes on $45,000. There are limits on deducting that contribution, depending on your income and if your employer offers a retirement plan.
A Roth IRA, named for Senator Roth from Delaware, is funded with after-tax money. There are income limits – if, as a single person, you made more than $144,000 in 2022, you are unable to contribute to a Roth IRA.[1]
There are no income limits on Roth IRA conversions. A conversion is when you move money from a traditional IRA to a Roth IRA. You can also do this within many 401(k)s, TSP, and other retirement accounts. Normally, when you move money from the traditional bucket to the Roth, you pay taxes on whatever money is moved, or converted.
If you make too much money to deduct your traditional IRA contributions, you can still fund the traditional IRA account. Because you can’t deduct the contribution, it’s after-tax money. When you convert it to a Roth, you are moving money you’ve already paid taxes on, so no additional taxes are due. It’s a legal way to fund a Roth IRA when you make too much money to contribute directly to a Roth.
There is one catch. The strategy doesn’t work if you have pre-tax money in any IRA account. You can’t convert just the after-tax money. You have to convert in proportion to the way the traditional account was funded. For example, if you had $45,000 in a traditional IRA that was all pre-tax, and you added $5,000 that was non-deductible, or after-tax, 90% of the account is pre-tax and 10% is after-tax. If you convert $5,000, $4,500 would be pre-tax and $500 would be after-tax. You would owe taxes on the $4,500 pre-tax money that was moved.[2]
One option to avoid this is to move your pre-tax IRA funds into your 401(k) or other employer-sponsored plan. This allows you to have only after-tax contributions in your traditional IRA when you convert to the Roth account.
Why would you want to fund a Roth account? If you meet all the IRS guidelines around withdrawals, the money grows tax-free, and distributions are tax-free.[3] Roth accounts are not subject to Required Minimum Distributions.[4] It’s important to discuss this strategy with your tax and financial advisors. Depending on your income now and your projected income in retirement, traditional contributions may make more sense. The Backdoor Roth strategy is typically used for additional savings, after your employer plans are fully funded.
Your action item this week is to check your estate plan. We recommend reviewing it every five years to be certain it is still in line with your wishes and check with your estate attorney to be certain it hasn’t been affected by any legislative changes.
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Investment advice offered through Great Valley Advisor Group, a Registered Investment Advisor. Tax advice offered through CovingtonAlsina Tax Services.
All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
The opinions voiced in this show are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which strategies or investment(s) may be appropriate for you, contact the appropriate qualified professional prior to making a decision.
[1] www.irs.gov
[3] www.irs.gov
[4] www.irs.gov