If a penny saved is a penny earned, then strategies for managing losses, fees, and taxes should be core undertakings of growing your wealth. Let’s zero in on a strategy for tackling taxes — or at least minimizing the erosion they can have on long-term wealth-building.
The usual framing
When it comes to deciding whether it is better to contribute to pre-tax account options or Roth, the decision centers on an estimation of which one is likely to produce the greatest after-tax outcome over time. It goes something like this: “If I’m in a low tax bracket now and expect it to be higher later, I should skip the tax break now and contribute to Roth so I’ll owe nothing in the future.”
In theory, that assumption holds. But unless the person is young or has very low income, the decision is generally not binary. What if, instead, a current tax break could be had and the advantages of Roth could be had in the future as well?
Enter the Roth conversion
Converting pre-tax monies to Roth is a simple process of recognizing the amount being converted as income in the current year, paying the tax associated with that income, and shifting the funds into the Roth structure. There is more than one avenue for doing this, and more than one type of conversion, but for now let’s keep it simple.
For many of us, our marginal tax bracket changes over time: starting out low, moving higher as our careers advance, and then generally declining again as we transition from actively working for income to producing income passively through investments and other sources. Life events — getting married, starting a family, buying a home, going back to school, starting a business — also have the potential to change our tax picture and thus our strategy.
By now you can picture a scenario where contributing pre-tax to gain an immediate tax advantage and converting to Roth at a later point can make sense. The opportunity could come from being temporarily in a lower tax bracket, from offsetting deductions that make recognizing additional income less onerous, or simply because investment values are down and expected to rebound.
What that flexibility looks like in retirement
Picture this: a retired couple needs to withdraw $60,000 per year from their investment accounts, and because they made strategic conversions along the way, they now hold large balances in both pre-tax and Roth IRAs. Having the flexibility to draw from both gives them more control over their tax liability.
Using the figures from when this example was first written: assuming no other income and the standard deduction, the first $24,800 drawn from pre-tax IRAs is offset by the deduction, leaving taxable income at zero. Taking the remaining $35,200 from Roth keeps them at zero. More important than owing no tax that year is the control they have gained by holding both tax types. And notice: because the pre-tax withdrawal was absorbed by deductions, there was no need to have given up the deductible contribution in the first place. Had everything been Roth, that opportunity would have been wasted.
Strategies like this get even more interesting when capital-gain assets enter the equation, but that is a topic for another day.
More than one door into the Roth
As Judge Learned Hand wrote nearly a century ago, “Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s taxes.” Roth strategies are core to arranging one’s affairs for tax efficiency, and conversion is only one of the doors in. Depending on your income, your employer’s plan, and your savings rate, several routes may be open at once.
Direct contributions
For those who qualify, the most straightforward way to fund a Roth IRA is to walk money in through the front door. As with any IRA contribution, earned income is required, and eligibility phases out above income limits the IRS adjusts most years. Annual contribution limits apply as well, with an additional catch-up amount for those 50 and over.
The back-door Roth
Many people who would like the tax-free growth a Roth IRA offers earn too much to contribute directly. Since 2010, however, taxpayers at any income level have been allowed to convert IRA balances to Roth. Because anyone with earned income may contribute to a traditional IRA, a two-step path opened up: make a non-deductible contribution to a traditional IRA, then convert it. The account holds only after-tax money, so little or no additional tax is due on the conversion.
There is a caveat, and it is the aggregation of IRAs and the pro-rata tax treatment applied to them. If you hold $54,000 of pre-tax money in one IRA and contribute $6,000 after-tax to another, a conversion is treated as coming 90% from pre-tax dollars and 10% from after-tax, and tax is owed accordingly. One way to clear the decks is to roll pre-tax IRA balances into an employer-sponsored plan, which is not counted for IRA conversion purposes, before using the back-door strategy.
The Roth 401(k)
Most employer retirement plans now include a Roth option, and no income limit applies, so anyone with access can use it. For people who are young or in a low marginal bracket, giving up a deduction today in exchange for tax-free withdrawals later can be attractive. Despite the common belief that tax brackets fall once working years are in the rearview mirror, that is often not the case: tax law changes, and diligent savers can find that required minimum distributions force them to recognize more income than they need. Roth accounts, by contrast, carry no required minimum distributions during the owner’s lifetime under current law.
The mega back-door
Some 401(k) plans accept “after-tax” contributions beyond the regular salary-deferral limit, up to the much higher overall limit on total plan contributions. Like the back-door Roth, those after-tax dollars can then be converted to Roth. For someone living well below their means, or already sitting on substantial savings, the ability to put that much more away with Roth treatment is the best of both worlds. Whether this door is open depends entirely on your plan’s rules.
And the fifth door is the one this article is about: converting money already sitting in pre-tax accounts. Each route can stand alone, but they work best in combination, matched to your income and bracket year by year. As the saying goes, it’s not what you make, but what you keep, that matters.
Not a set-it-and-forget-it decision
Knowing how much to convert, and when, is part of ongoing planning — not a one-time choice. Tax brackets, account balances, and life circumstances all move, and the conversion strategy should move with them.