Helping Clients Catch Up on Retirement Savings
According to the 2017 Retirement Confidence Survey, only 56 percent of American workers are currently saving for retirement. The survey also found that "a sizable percentage of workers say they have no or very little money in savings and investments." These statistics illustrate a critical role for advisors in retirement planning: helping clients catch up on retirement savings. One potential solution? The backdoor Roth IRA.
Made possible by a 2010 provision to the Tax Increase Prevention and Reconciliation Act of 2005, the backdoor Roth IRA presents an opportunity for some individuals to potentially put away more money for retirement, in a tax-advantaged way.
As you may know, contributions to a traditional IRA are tax-deductible—but only for individuals within a certain income threshold if they are covered by a workplace retirement plan. While individuals with income over the limit can still contribute, those contributions will not be deductible. For Roth IRAs, on the other hand, a similar income phaseout exists for those wanting to contribute, but there’s a twist.
That 2010 provision I referred to earlier retained modified adjusted gross income (MAGI) limits on Roth IRA contributions, but it eliminated the MAGI limits on Roth IRA conversions. The result? If your clients earn too much to contribute to a Roth IRA (and to make tax-deductible contributions to a traditional IRA), they can:
- Fund a Roth by making a nondeductible contribution to a traditional IRA
- Convert that amount to a Roth (in some cases, tax-free)
This backdoor Roth IRA contribution strategy can be highly effective for creating tax-free income in retirement, but it’s also quite complex. It’s important for you to understand the benefits, which clients are right for this strategy, plus potential tax implications and challenges.
Some of the benefits of accumulating retirement assets in a Roth IRA include:
But for those clients who have been phased out of being able to contribute to a Roth in the usual way, there is an additional benefit: the ability to put away more money for retirement. Let's look at an example to help illustrate this point.
A married couple in their 40s comes to you concerned that they didn’t start saving for retirement early enough and would like to catch up on their savings. They file jointly, are both employed, but have maxed out their 401(k) contributions. Neither of them owns an IRA because their MAGI has precluded them from making deductible IRA contributions, as well as Roth contributions. What can they do?
With the backdoor Roth IRA strategy, they can each make a $5,500 (for 2017) nondeductible IRA contribution and immediately convert it, tax-free, to a Roth IRA. Let's say each of them contributes $5,500 annually over the next 20 years. With a conservative rate of return of 5 percent, they each could potentially accumulate $190,956!
In many ways, holding assets in a Roth IRA instead of a traditional IRA can benefit almost anyone. But it can be particularly beneficial for the "right" clients:
- Clients who earn too much to make deductible IRA contributions or contribute to a Roth, as the investment earnings in the Roth will grow tax-free
- Clients with a long time horizon to retirement
- Clients who have maxed out their 401(k) contributions
Keep in mind that because the backdoor contribution starts with a contribution to a traditional IRA, your client must be younger than 70½. And there is one other factor to consider: whether or not your clients have an existing IRA.