Part 4: Tax Planning Around Your IRA

The Tax Planning pillar is timely given the end of the year is approaching and the window for executing specific strategies for the taxable year is closing soon. As employees with set annual salaries, educators have the unique benefit of knowing where their tax bracket will line up for the year, so end of year planning can be extremely effective. The potential variable to this scenario is the spouse of the educator, and what his/her line of work and annual compensation looks like, which cements the need for efficient tax planning at year end.

I wanted to spend this week centering on one specific concept for educators, as it is something I see frequently overlooked. It is the topic of correctly executing a backdoor Roth IRA. Due to the IRS rules about Roth IRA eligibility relating to direct contributions, many individuals immediately assume there is no way they can fund a Roth IRA if they are not eligible based on their tax bracket. This is a large misconception, and I find most people have never heard of this strategy.

Backdoor Roth IRA Contributions

Given the fact educators have a fairly concrete earnings schedule, forecasting the end of year tax bracket is rarely difficult. As mentioned above, spousal income is usually the variable that makes it challenging, but for sake of simplicity, let’s assume each spouse is an educator in this example.

We also need to work under the assumption that there are no other funded IRAs for the individuals in this scenario. If you have a rollover IRA or have funded a Traditional IRA in the past – if you have a balance in an IRA – the conversion of dollars into a Roth IRA is executed in a different manner, and it is recommended you speak with your advisor or tax professional before following these steps.

The IRS says if you are married filing jointly and your income exceeds $196,000, you are limited on what you can contribute into a Roth IRA. However, there is a phase out period between $196,000 – $206,000, which means you can only make partial contributions to your Roth. If you and your spouse have a modified adjusted gross income (MAGI) over $206,000 combined, you are prohibited from a direct Roth IRA contribution. Here is a little summary below:

What is your combined Modified Adjusted Gross Income (MAGI)?

  • $1 – $196,000: Can make a full and direct contribution for each spouse (Eligible)
  • $196,001 – $206,000: Can make a partial direct contribution (Phase out period)
  • $206,000 (+): Cannot make any direct contributions (Fully phased out)

Oh wait, there’s a backdoor.

The backdoor Roth IRA is made in three simple steps. First, you must have two IRAs opened at a custodian. A Traditional IRA and a Roth IRA. Second, you make a non-deductible cash contribution to your Traditional IRA. If you are under 50 years old the 2020 maximum contribution is $6,000. If you are over 50 you can contribute $7,000. Make the maximum contribution according to your age into the IRA, but do not invest that cash. Third, once the cash settles in your IRA (usually three business days depending on the custodian) you can execute a proper backdoor Roth conversion from the IRA to the Roth IRA by filling out the appropriate paperwork at the custodian. Once the money is in the Roth, the ‘backdoor’ has officially been executed. You can now invest in the Roth for the long-term. This method is allowed is because you made the contribution to the Traditional IRA first, then simply converted the non-deductible Traditional IRA contribution by moving it to the Roth IRA.  

(Side note: you must be aware certain distribution rules do apply for Roth IRAs).

You have now legally funded your Roth IRA for the year, and the beauty is you can continue to execute and plan around this strategy perpetually – every year can bring about new planning opportunities, no matter which tax bracket you find yourself in.

My team and I specialize in finding value for every individual we plan for, and year-end tax planning is full of opportunities to bring nooks and crannies of value and education to your life. A backdoor Roth isn’t for everyone, but this is an amazing technique to use if you qualify for it. Want to learn more about what we can do for you? Start here.

Diversification and asset allocation do not ensure a profit or guarantee against loss.

The views and strategies described may not be suitable for all investors. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for accounting, legal or tax advice. References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.

The views expressed are those of BerganKDV Wealth Management. They are subject to change at any time. These views do not necessarily reflect the opinions of any other firm. Investment advisory services and fee-based planning offered through BerganKDV Wealth Management, an SEC Registered Investment Advisor.


CATEGORIES: Wealth Management
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