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Does a backdoor Roth individual retirement account make sense? How to decide

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  • A popular retirement savings tactic is on the chopping block in Congress, and investors are eyeing the strategy before it disappears.
  • Those considering a backdoor Roth individual retirement account need to weigh several factors — upfront bills, future tax brackets, the waiting period and the consequences of boosting income.

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A popular retirement savings tactic is on the chopping block in Congress, and investors are eyeing the strategy before it disappears. But there are other things to consider before making changes, financial experts say.  

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Currently, investors can skirt the income limits for a Roth individual retirement account by using a so-called backdoor maneuver. 

Investors can make what’s known as nondeductible contributions to their traditional IRA before converting the funds to their Roth IRA. The future tax-free growth may be appealing if they expect a higher bracket in retirement.

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House Democrats want to crack down on the after-tax backdoor strategy, regardless of income level, after Dec. 31, according to a House Ways and Means Committee summary

While some investors are eager to complete the move before year-end, advisors urge caution, particularly with legislation in flux.

“It’s one of those things that you can’t look at in a vacuum,” said Marianela Collado, a certified financial planner and CPA at Tobias Financial Advisors in Plantation, Florida, explaining investors need to take a holistic approach.

Cover the tax bill

Roth conversions may trigger levies on pre-tax contributions or earnings, so investors will need a plan for covering the bill.

“You need to be mindful of whatever taxes you’re going to incur, based on the conversion,” said Ashton Lawrence, a CFP with Goldfinch Wealth Management in Greenville, South Carolina.

Moreover, someone willing to pay upfront taxes on a Roth conversion may need to project how many years it will take until they break even, Collado said.  

However, some investors opt for taxable Roth conversions in years with lower income or other deductions to offset the levies.

Five-year rule

While Roth IRAs typically offer tax and penalty-free withdrawals anytime for contributions, there is an exception for conversions, known as the “five-year rule.”

Investors must wait five years before they can withdraw converted balances, regardless of their age, or they will incur a 10% penalty. The timeline begins on Jan. 1 on the year of the conversion.

Increased income

Another possible downside of a Roth conversion is the potential to increase that year’s adjusted gross income, which may cause other issues, Lawrence said.  

“It’s like a balloon,” he explained. “If you squeeze it at one end, you’re going to inflate it somewhere else.”

For example, Medicare Part B and Part D base monthly premiums on modified adjusted gross income from two years prior, meaning 2021 income may trigger higher costs in 2023. 

Someone with a modified adjusted gross income above $88,000 ($176,000 for joint filers) will have an added surcharge every month, known as the Income Related Monthly Adjustment Amount or IRMAA.

In 2021, the extra charges for Medicare Part B and Part D may be as much as $504.90 and $77.10, respectively.  

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