I have a favorite saying that bears repeating: “Investing is like a stool with three legs: Market Risk, Liquidity, and Taxes.” Each one of these factors could either wreak havoc or greatly enhance your overall financial plan at a given point in time. In the unforgiving world of finance, not knowing is not an excuse. Each of these three metrics is present in every investment decision and it’s on you, as the financial advisor, to know how to score it. Let’s focus on taxes.
The opportunity exists because there is no income limit for non-deductible contributions and no income limit for Roth conversions.
Bryan Kuderna
There are ultimately three different forms of taxability when you put a client’s money to work: taxable, tax-deferred, and tax-free. Taxable essentially means the account or investment is taxed as you go. These are the types of accounts that could generate a Form 1099 every year, disclosing investment income such as interest, dividends, or capital gains. In 2021, qualified dividends are taxed as long-term capital gains, traditionally at lower rates than ordinary income tax rates. Most interest is taxed as ordinary income, with some exceptions like municipal bond interest. In regard to the actual buying and selling of investments, assets held for more than 12 months receive the preferential long-term capital gains rate that peaks at 20%, while gains on assets held for less than 12 months are taxed as ordinary income. These vehicles usually offer a higher level of liquidity (ability to access money), but paying taxes every year can chew away at any returns.
The second category of tax-deferred includes vehicles that defer or postpone the eventual tax liability. (Please note, it is deferred, not eliminated or saved, as can be often misquoted.) The most common incidence is in that of a traditional 401(k), individual retirement account (IRA), or similar “pre-tax” retirement account. In these scenarios, contributions evade current income tax, but as the investments compound, so does the future unknown tax liability. Non-qualified annuities offer another method to take “post-tax” investments and defer taxes until a future time. The caveat is, no one can accurately predict tax rates in an upcoming administration, let alone rates possibly decades away in retirement.
The third major form of taxability is tax-free. These are “post-tax” investments (except maybe in the case of a health savings account or HSA), in which principal and gains can be withdrawn without tax consequence, so long as certain rules are followed. Some popular vehicles in this category could be 529 plans, cash value life insurance such as whole life, or Roth IRAs. Many investors may appreciate the idea of eliminating one of the biggest future unknowns of taxes or the luxury of looking at a statement in retirement and saying, “That number is all mine.”
A Roth IRA can offer some very unique tax advantages, but the gripe many clients will have is: “I make too much money.” If a client is single and makes more than $125,000, married filing jointly and makes more than $198,000, or married filing separately and makes more than just $10,000, they may not be able to contribute. If your client’s employer offers a 401(k), they likely now have a Roth contribution option to go along with the traditional pre-tax method — and there are no income limits on Roth contributions to workplace retirement plans.
If a Roth 401(k) is not an option, or your client wants to put away even more money to grow tax-free, but they are making too much money for the Roth IRA, consider the “backdoor Roth IRA.” This is not an actual type of account, but rather an IRS-sanctioned strategy for high-earners. The process involves making a non-deductible contribution to a traditional IRA (filing Form 8606), and then converting that balance into a Roth IRA.
The opportunity exists because there is no income limit for non-deductible contributions and no income limit for Roth conversions. Investors need to be extra careful if there have been any gains on that original non-deductible contribution, as those gains will be taxed on the way over, or if they have multiple IRAs.
The IRS uses a pro-rata rule which essentially says you can’t cherry-pick the after-tax money out of your IRA to convert, but rather a portion of all pre-tax monies will be assumed to have been converted, triggering a tax consequence on the way over. The simplest method involves having one traditional IRA and one Roth IRA, making one annual non-deductible contribution to the traditional IRA, and converting it before any gains or interest accrues.
It might seem like a lot of legwork to get the same outcome as someone making less than the income limits, but these are the rules. As you focus on each leg of the investment stool, a Roth IRA, or a backdoor Roth IRA, might be something to consider.