Beyond Roth: Comparisons to a Traditional IRA & Backdoor Conversions
Your Retirement Roadmap: Because GPS Doesn't Work for Your Financial Future
Before the break, we dove deep into the Roth IRA, a powerful tool for tax-free retirement savings. Today, we'll expand our exploration to include Traditional IRAs and the strategic "Backdoor Roth" conversion.
Traditional IRAs
A Traditional IRA is a retirement account that offers tax-deductible contributions (if you meet certain income requirements) and tax-deferred growth. Essentially, you pay taxes on your withdrawals in retirement, not when you contribute. This can be advantageous if you expect to be in a lower tax bracket later in life.
Roth or Traditional? Everyone has an Opinion
The choice between Roth and Traditional hinges on several factors, including:
Current vs. Future Tax Rates: If your current rate is higher than your projected retirement rate, a Traditional IRA may be more beneficial due to the upfront tax deduction. Consider your expected tax bracket here.
Income Limits: Roth IRAs have income limits for contributions, while Traditional IRAs do not (though deductibility may be limited).
Need for Flexibility: Roth IRAs allow penalty-free withdrawals of contributions (not earnings) at any time, providing a safety net in case of emergencies. Traditional won’t let you do that.
The Backdoor Roth: A Strategy for High Earners
If your income exceeds the Roth IRA contribution limits, the "Backdoor Roth" conversion strategy might be your ticket to tax-free retirement income. T. Rowe Price discusses some advantages and disadvantages here. This is not a special account but a strategy of taking a Traditional IRA account & converting it over to Roth (this is not a rollover, it’s a conversion, big difference on wording). During taxes, you will need to file Form 8606, per the IRS.
Backdoor Roths: How it Works:
Contribute to a Traditional IRA (non-deductible).
Convert the Traditional IRA to a Roth IRA, paying taxes on any earnings.
Repeat annually, up to the contribution limit.
When Does it Make Sense to Consider the Backdoor Roth?
High Income: If you can't contribute directly to a Roth IRA due to income limits.
Expectation of Higher Future Taxes: By paying taxes now, you avoid potentially higher rates in retirement. If you think you will be in a higher tax bracket in the future or you think tax rates in general will increase in 10, 20, 30+ years, this may be something for you to consider.
Tax Diversification: Adding a Roth IRA to your portfolio can provide flexibility in managing your taxable income during retirement.
Wells Fargo posted a nice list about some common scenarios to consider for your situation here.
Backdoor Roth Before Retirement: A Smart Move?
Converting to a Roth IRA before retirement can be a strategic play, especially if you anticipate higher taxes later on. By doing so, you'll lock in your current tax rate on the converted amount and enjoy tax-free growth thereafter. This is a great approach if, at the start of retirement, have a lower income & are OK with not touching the money for the first 5 years. Forbes talks about this more here.
Pro-Rata Rule Considerations:
If you have existing Traditional IRA funds (pre-tax), the pro-rata rule might come into play during conversions. It calculates the taxable portion of your conversion based on the ratio of pre-tax to after-tax funds in all your Traditional IRAs. This can make backdoor Roth conversions less tax-efficient in some cases.
Tax Deductions and Your IRA
Traditional IRAs offer potential tax deductions, but whether your contributions are deductible depends on your situation. The IRS sets income limits for deducting Traditional IRA contributions, varying by filing status (single, married filing jointly, head of household). You can find the current limits on the IRS website.
If you or your spouse participates in a workplace retirement plan (e.g., 401(k)), your deduction may be limited or phased out based on income. If neither of you has a workplace plan, contributions are generally fully deductible.
Your Modified Adjusted Gross Income (MAGI) also impacts deductibility. If your MAGI is below a certain threshold, your contributions may be fully deductible. If your MAGI falls within a phase-out range, you might be able to deduct a partial amount. However, if your MAGI exceeds the upper limit, your contributions may not be deductible at all. Investopedia goes much further in-depth on this topic here.
The Bottom Line
Traditional IRAs, Roth IRAs, and backdoor conversions offer a range of options for retirement savers. The best approach for you will depend on your individual circumstances, financial goals, and risk tolerance.
As always, I encourage you to seek guidance from a financial advisor to create a personalized retirement plan that aligns with your unique needs.
.M