Nola Kulig
Kulig Financial Advisors
Longmeadow, MA, 01116 USA
413-565-2839
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Roth Savings Strategies for High Earners: Strategy #1 – the Back Door Roth IRA

May 30th, 2016

Roth IRAs and 401(k)s are wonderful savings vehicles. Although you cannot claim a tax deduction for them, their earnings are untaxed and there is no income tax due when withdrawn in retirement, providing some requirements are met.

Whenever possible, we recommend some portion of savings be devoted to Roth accounts. Ideally, entering retirement, one would have a mix of tax deferred savings (traditional IRAs and employer savings), taxable money, and Roth money. This provides multiple ways to draw down your accounts in retirement and provides much more flexibility in tax planning.

However, if you are a high earner while employed, it can be difficult to contribute to Roth accounts because:

  • There are limits on income for direct contributions to Roth IRAs. In 2016, Roth IRA contributions phase out starting at $184,000 for married filing jointly taxpayers, and they are completely eliminated at $194,000.
  • High earners frequently need to take full advantage of salary reduction plans at work to lower their taxes; thus, even if their employers offer Roth options, they may not feel they can take advantage.

The Back Door Roth IRA

Starting in 2010, Congress changed the rules for converting from a traditional to a Roth IRA. Beginning with that tax year, there is no longer an income limit on converting a non-deductible traditional IRA to a Roth IRA.

So how do you do this? There is one potential pitfall to be aware of, but with some planning, you can take advantage of this strategy for additional tax savings.

Important Condition Prior to Making the Contribution

Before using this approach, make sure that you do not have any SEP-IRA, SIMPLE IRA, traditional IRA, or rollover IRA money.  The total sum of these accounts on December 31st of the year in which you do Step 3 must be zero to avoid a “pro rata” calculation that can eliminate most of the benefit of a Backdoor Roth IRA.

The pro-rata rule is often referred to as the cream-in-the-coffee rule. Once the cream and coffee are combined you cannot separate them; in the same way, blending before-tax and after-tax funds in any Traditional IRA(s) cannot be separated. This is true even if you keep the before-tax amounts in a different Traditional, IRA from the after-tax amounts, as the values of all Traditional IRA(s) are combined for purposes of determining the percentage of any distribution or conversion that is taxed.

So how to deal with existing traditional IRA money?

  • Convert the entire sum to a Roth IRA. This approach is really only practical if it does not bump you into a higher tax bracket and you can afford to pay the taxes out of current earnings or taxable investments with relatively high cost basis.
  • Roll the money over into a 401K, 403B, or Individual 401K.  401Ks don’t count in the aforementioned pro-rata calculation.  Some people have even opened an Individual 401K that accepts IRA rollovers in order to facilitate a Backdoor Roth IRA.

Contribute to a non-deductible IRA

Next, make a $5,500 ($6,500 if over 50) non-deductible traditional IRA contribution for yourself, and one for your spouse.  You can use the same traditional IRA accounts every year, leaving the account open after you make the conversion.  (Most fund companies don’t close the account just because there is nothing in it most of the year).  I do this every January and place the contribution in a money market fund. Since it yields next to nothing, you will not have much in the way of gains that could be taxed at conversion; you will also not have any losses.

Convert the non-deductible IRA to a Roth

Convert the non-deductible traditional IRA to a Roth IRA by transferring the money from your traditional IRA into your Roth IRA at the same fund company.  If you don’t already have a Roth IRA account, you’ll need to open one.  This can easily be done online at most fund companies.  The transfer is considered a taxable event, but the tax bill should be zero if you initially put the money in cash as described earlier.  Once the money is transferred to the Roth, you can invest the money according to your investment plan.

The Step Transaction Doctrine

Some people are concerned that the IRS will have a problem with the Backdoor Roth due to an IRS rule called The Step Transaction Doctrine.  This rule says that if the sum of several legal steps is illegal, then you can’t do it.  Since a high earner can’t legally make a direct Roth IRA contribution, then some have wondered if the IRS will really allow them to use the back door Roth strategy.

Some experts recommend waiting a short period of time (anywhere from a day to six months) before doing the conversion so you can prove that wasn’t really your intent.  Another method to avoid the Step Transaction Doctrine is to convert last year’s non-deductible contribution this year, then make a new non-deductible contribution for this year to “introduce economic uncertainty” as to whether you’re going to convert or not.

Fortunately, many fund companies will not let you do your Roth conversion immediately; mine will not allow a conversion for about two to three months (I have not tracked the actual time, but have just gone back periodically to see if I can do the conversion yet). This helps safeguard against tripping the Step Transaction Doctrine.

When you do your Taxes

When you do your taxes for the year of the conversion, remember to fill out Form 8606 for each person funding a non-deductible IRA.

Congratulations, you are now accumulating Roth money! There are a few steps and things to be aware of, but it is not too difficult and provides you a tax-free source of money in retirement. Make it a habit to fund one every January for both yourself and your spouse if married, and head for financial independence!

 

Your 1040: What it Says About You

May 1st, 2015

It was with a sigh of relief that I completed our family’s tax work this year (full disclosure: we have a CPA prepare ours, but I did my mother’s—-hers is simpler, and it saves her a bit of money).

However, rather than just filling out the forms to get the job done, a careful review of your 1040 can frequently reveal some tax-savings steps you can take. Many are simple; others, if not complex, may mean some extra work on your part (or your advisors), but can be well worth the effort.

The following are just a sampling, given the complexity of the tax code. These are the more straightforward items from the first page of Form 1040. Why focus on this page? At the bottom is an important number: adjusted gross income (AGI). AGI is important because it determines whether you can claim certain deductions and credits.

If you prepare your return yourself, you should be in a good position to evaluate what you can do in the following areas. If not, at a minimum, you will want to review your return and discuss things with your tax advisor; one of the most telling questions is “what can I do to reduce my taxes for 2015?”

Line by Line

Line 7 – Wage, Salaries and Tips

This first step you can take to reduce taxes (assuming you are employed) doesn’t even show on line 7–wages, salaries and tips. That is because it has to do with your 401(k) contributions.

Assuming you are contributing to a traditional (not Roth) 401(k), these contributions are not reported on your line 7. Instead, they reduce your salary or wages. So the first obvious solution to reducing taxes is to make sure you are maximizing your 401(k) contributions. The fact that you may get an employer match on your savings is a bonus.

Lines 8a and 8b, Taxable and Tax Exempt Interest

Take time to evaluate the mix of taxable and tax exempt interest on your return. The proportion of each that is desirable depends on your tax bracket and the level of interest available on each. Each time you consider an interest-bearing savings account or investment, you should compare it to the tax-equivalent yield for a tax exempt investment to that available on a taxable one to see which is best for you.

The calculation for taxable-equivalent yield is:

 Tax equivalent yield = tax-free municipal bond yield/(1-tax rate)

The tax rate referred to in this equation is your marginal rate (which you can think of as the rate of tax you pay on each additional dollar of income—this is not your average tax rate, which would be your total tax divided by total taxable income). Your marginal tax rate can be determined by reviewing the tax tables at www.irs.gov. This is a good number to know for all sorts of financial planning questions.

In general, those in higher tax brackets usually benefit from having more tax exempt interest, while those in lower brackets usually are OK with more taxable interest. So if you are in a high tax bracket and have lots of taxable interest on your 1040, it may be time adjust your portfolio. Likewise, if you are in a lower tax bracket, but were attracted to tax exempt bonds to lower your tax bill, make sure you have not unnecessarily sacrificed interest income.

Since rates change constantly, there are times where even lower bracket tax payers may benefit from municipal bond income, so please check every time you consider making an investment.

Lines 9a and 9b – Total Dividends and Qualified Dividends

Your tax here depends on what kind of dividends you’re receiving: qualified or non-qualified.

Most dividends can be referred to as “ordinary” or “non-qualified” dividends, and they’re going to be taxed like any other income you report.

This brings us to qualified dividends, which have their own tax requirements and exceptions. The good news about qualified dividends is that they’re taxed at a lower rate. They’re considered capital gains, because you have to hold your stock for a certain number of days.

Your tax bracket is going to influence your qualified dividends tax rate. And here’s something nice: If you’re in the 10 to 15 percent bracket, then you’re not going to be taxed anything on qualified dividends. If you’re in the 25 to 35 percent tax bracket, your qualified dividends will be taxed at 15 percent. In a bracket above 35 percent? Well, lucky you – but you’ll have to pay 20 percent on those qualified dividends and long-term capital gains, but this is still lower than regular income tax rates.

When selecting investments, you don’t want to have the tax tail wag the investment dog. But in your taxable accounts, if you have a choice between equivalent investments that will pay qualified dividends versus those that do not, it is clear which you would want to choose.

Is this giving you a hint about where you want to own different investments? The issue of where to hold your investments to the best tax advantage is called “tax location.” In general, you want to hold interest bearing investments where the income is taxed at regular income rates in tax deferred (traditional IRAs, 401(k)s, etc.) and those potentially taxed at capital gain rates in taxable accounts. You want to benefit from capital gains rates as much as possible in taxable accounts.

Line 13 – Capital Gain or Loss

As mentioned earlier, capital gains are taxed at rates lower than those for regular income. You can also use losses to offset gains as follows:

  • Offset capital gains that were held less than a year by using your current capital losses. These are call short-term gains and taxed at your regular income tax rate at whatever tax bracket you are in.
  • Use the remaining losses to offset the gains that were held more than a year. These are long-term gains and eligible for the capital gains tax rate.
  • If your losses exceed your gains, you may deduct up to $3,000 of losses on your current year tax return.
  • Losses in excess of your gains and your $3,000 allowance can be carried forward to next year. With the excess, you can offset next year’s capital gains or use up to another $3,000 loss.

Line 25 – Health Savings Accounts

health savings account (HSA) is a tax-advantaged medical savings account available to taxpayers who are enrolled in a high-deductible health plan. The funds contributed to an account are not subject to federal income tax at the time of deposit. HSA funds may currently be used to pay for qualified medical expenses at any time without federal tax liability or penalty. Withdrawals for non-medical expenses are treated very similarly to those in an individual retirement account (IRA) in that they may provide tax advantages if taken after retirement age, and they incur penalties if taken earlier.

A full discussion of considerations of whether an HSA is appropriate for you is beyond the scope of this short discussion. But it is something worth researching and determining whether it is appropriate for your situation. If so, you have an opportunity to reduce your AGI.

Line 28 – Self Employed SEP, SIMPLE and Qualified Plans

If you work for yourself rather than for an employer, there are still tax incentives to save for retirement. If you have not established a plan for any self-employment income, consider increasing your retirement security and reducing your AGI at the same time.

Line 29 – Self Employed Health Insurance Deduction

We are all required to have health insurance since the introduction of the Affordable Care Act. If you are self-employed, you can receive a tax deduction for the premiums.

Some of us pay quite a lot to insure a family, even when it is through an employer plan. If you have a spouse with self-employment income, you may want to check whether your after-tax premiums are lower if the spouse takes out his/her own health policy. You may even want to check on insuring the family through that policy, depending on your circumstances.

Line 32 – IRA Deduction

If you don’t have an employer 401(k), or if you can save over and above those contributions, you may be able to use an Individual Retirement Account and deduct that contribution. Income levels and other factors affect your ability to take a deduction, so please check the rules and use the worksheets to calculate whether you can take one or not.

Summary

This is hardly an exhaustive list of ways to save on your taxes. But a simple review of a few key items has potential to help save you money the next time April 15th comes around.

On that note, let’s look forward to spring, with taxes done, planning for next year complete and warmer weather on the way!

IRA Rollovers: Important Rule Changes

May 9th, 2014

We have historically recommended that clients do trustee-to-trustee transfers when transferring assets from 401(k) to IRAs. But a recent ruling gives you yet another reason to avoid taking a check and along with it, the responsibility of making the rollover within a short window of time to avoid penalties.

Please see http://www.usatoday.com/story/money/personalfinance/2014/04/06/irs-ira-rule-change-rollover/7317035/ for a summary. The story covers a recent decision by the United States Tax Court that states a taxpayer can perform only one tax-free “rollover” of an individual retirement account each year — regardless of how many IRAs they may have.

While this situation should not impact many IRA owners, it is something to be aware of if you have several IRAs. For example, those who may have several IRAs sprinkled between many bank accounts could be affected. In addition to making a case for trustee-to-trustee transfers, this ruling makes our usual recommendation to consolidate accounts even more appealing. Perhaps it is time to spring clean finances along with the house and garden!

Investment advisor representative of an investment advisory services offered through Garrett Investment Advisors, LLC, a fee-only SEC registered investment advisor. Tel: (910) FEE-ONLY. Kulig Financial Advisors may offer investment advisory services in the state of Massachusetts and other jurisdictions where exempted.