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 Although you cannot claim a tax deduction for them, their earnings are untaxed and there is no income tax due when withdrawn in retirement, providing some requirements are met.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!

 

Social Security Issues Procedures and Deadline for File and Suspend Social Security Strategies

March 20th, 2016

This month’s post is a short, but potentially important follow up note on Social Security benefits. Last November, I wrote to make sure my readers were aware of the fact that Social Security “file and suspend” strategies were being significantly altered. Essentially they were eliminated for the vast majority of future Social Security recipients.

However, there is a short window where those who are already 66 may use a file and suspend filing. The Social Security office recently made an announcement clarifying a short window this spring during which those who have reached this age may file.

We relay their announcement in case it helps you by discussing:

  • New Social Security File and Suspend Guidelines
  • Watch out for Difficulties in Filing

New Social Security File and Suspend Guidelines

For a good summary of who may still use file and suspend, please see the article at http://www.investmentnews.com/article/20160219/FREE/160219920/social-security-issues-new-file-and-suspend-guidelines.

Some key details:

  • There is a short window where if you have not yet filed using this approach, you still may do so. If you are already 66, you have until April 29, 2016 to file for your own benefit, and then suspend them, allowing others to file for benefits based on your record. You could allow your own benefit to grow while they do so.
  • If you are not already 66, this window would not apply to you and you would not have this option. However, according to Garrett’s resident Social Security expert, Jim Blankenship, “anyone born on or before April 30, 1950 is considered to be at full retirement age during the entire month of April, 2016, so even if born on April 30, 1950 the filer should be in good shape if they want to use this provision.”
  • In addition, the filer who requests a suspension prior to April 30, 2016 can in the future ask that benefits are reinstated as of any date after the suspension request, up to the present date (lump-sum retro payment).
  • The official deadline of April 29 is one day earlier than originally announced.

Watch out for Difficulties in Filing

The fact that Social Security has announced these guidelines gives some hope that their personnel are clear on all the changes.

Having said that, please be aware that if you go to Social Security to make the April deadline, you may encounter issues. Earlier in the year, press indicated that filers were having difficulty in using a file and suspend strategy while they still could. Even those who met the guidelines just described were being told they could not file in this manner at all. (Please see http://www.investmentnews.com/article/20160217/BLOG05/160219941/some-local-social-security-administration-offices-refuse-to-process.) Postings within the Garrett Planning Network indicate that some of our clients have experienced issues as well.

So please go prepared and do not be surprised if all does not go smoothly. You may need to go up the foodchain at Social Security.  As an alternative, Mary Beth Franklin, another Social Security expert, recommends filing on-line at the Administration’s website at https://ssa.gov/. Apparently this is one situation where automation can pay off!

Budget Deal Kills File and Suspend Social Security Strategies

December 29th, 2015

At this time of year, I usually like to write to everyone about charitable giving and thankfulness for the blessings that have come our way in 2015. However, if you haven’t already heard, I need to communicate the impact of a recent Congressional budget deal on Social Security claiming strategies. I’ll briefly discuss giving, but only after you know why you may need to revisit your claiming strategy.

This month’s newsletter looks at the following topics:

  • Congressional Budget Deal’s Changes to Social Security Claiming Rules
    • Summary of Changes
    • Who is Impacted
    • What to do if this Impacts You

Congressional Budget Deal’s Changes to Social Security Claiming Rules

Summary of Changes

My initial reaction to the budget deal was “hooray!” since it meant we did not have to go over the fiscal cliff again.  But that was before I understood that in the deal were some of the biggest changes to Social Security claiming we have seen in many years.

Please go to http://www.investmentnews.com/article/20151028/FREE/151029902/budget-deal-would-nix-popular-social-security-claiming-strategies for a summary. In essence, the “file and suspend” claiming strategy for couples is going away, and it will go away quickly, if the deadlines in the bill are realistic. (The article in the link does express some skepticism at the speed with which this change can be implemented, since the wheels of government machinery turn slowly, but anything is possible.)

What this means is that there will be fewer options for taking Social Security benefits for couples. While this simplifies planning, it may also mean less money in your pocket. It certainly means that if you are a pre-retiree, if you used a file and suspend strategy, you should run the numbers again in your retirement plan to see what makes the most sense for you under the new rules.

Even though file-and-suspend may be going away, deferral of benefits still means a significant increase in benefits. But if the file-and-suspend strategy made a difference in the success of your plan, you may find you need to save more now that the approach is no longer available.

Who is Impacted

Obviously couples are impacted by these recent changes. But based on some press descriptions, you may think this does not impact you when in fact it does. There is a lot of talk about how this is only an option for “the wealthy” and that it is a loophole that should be closed. I disagree with the rhetoric surrounding this change. I can think of lots of middle class people who will be impacted who probably do not consider themselves “wealthy.” So any couple, regardless of income, should re-run their estimated claiming strategies.

Singles who were planning on using “file and suspend” to increase retroactive benefits if they changed their minds should also revisit those plans. Under the new rules, retroactive benefits no longer apply. Instead, you only receive your benefit effective at the time you decide to start benefits, including delayed credits.

There was a provision for the truly well off as well. The legislation also places a surcharge on high-income recipients of Medicare. This will be costly for wealthier retirees. Please see the article for the new surcharges. These pale in comparison to the elimination of “file and suspend,” however.

What to Do if this Impacts You

If file-and-suspend was part of your retirement plan, and if Social Security was a large part of your retirement plan, please get in touch to update those projections. This is a bigger issue if your retirement is imminent. If you are approaching retirement, but still have several years, you have time to save more, if necessary, to make up for less anticipated Social Security income.

If you are right on the cusp of claiming benefits, there is not much you can do, although there are some exceptions which do not apply to many filers. But at least you can prepare your income expectations and budget accordingly.

In either case, better to know than to use the ostrich strategy (head-in-the sand).

 

 

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.