Back-Door Roth IRA? Why Not Walk through the Front Door of an HSA?
by your Health Savings Academy | Originally posted on LinkedIn
A recent surge in articles about back-door Roths touts the advantages of Roth versus tax-deferred retirement accounts. But the tax savings associated with a Health Savings Accounts trump them both.
Some financial professionals are counseling their clients to open a back-door Roth IRA to diversify their tax risk in retirement. The strategy involves paying taxes now to enjoy tax-free distributions in retirement. But there's another way to achieve tax-free withdrawals in retirement without paying income (and payroll) taxes now.
This other way involves a Health Savings Account. Many financial advisors don't understand the power of these accounts. But in a few minutes, you will.
The Difference Between Tax-Deferred and Roth
Tax-deferred 401(k) plans and Individual Retirement Arrangements (IRAs) have been around for more than four decades. These plans allow Americans to fund retirement accounts with pre-tax (401(k) plans) or tax-deductible (IRAs) contributions. With no federal or state taxes applied to contributions, each $100 of sacrifice of current consumption will result in a $92.35 (the 7.65% federal payroll taxes aren't waived) contribution for most taxpayers. If contributions were taxable, the deposit would be closer to $75. Thus, this tax treatment allows participants and account owners to amass larger balances more quickly.
Growth from investing balances is tax-deferred. But all distributions are included in taxable income. And beginning at age 72, account owners must make Required Minimum Distributions (RMDs). A formula based on age and account value determines the annual RMD. These distributions are mandatory because the federal government wants to begin to realize tax revenue on these funds. [Technically, they're not mandatory per se. If your RMD is, say $20,000 in 2022, you can pay a $10,000 penalty and retain the $20,000 in your retirement account.]
Roth Accounts are a newer form of saving, dating back to the late 1990s. The tax treatment is the reverse of tax-deferred accounts. Contributions are post-tax (so the $75 figure above is a general representation of how much of a $100 sacrifice of current income will produce in contributions after paying federal and state income taxes, plus federal payroll taxes). Growth is tax-deferred/tax-free. All qualified distributions (essentially, withdrawals after age 55) are tax-free. There are no RMDs associated with a Roth IRA, since federal and state governments have already taxed the money during the contribution stage. [Note: Roth 401(k) balances are subject to RMDs, so it may be advisable from a tax perspective to roll over funds from a workplace Roth to a Roth IRA if possible.]
The Roth Advantages
The Roth advantages are simple:
Tax the seed, not the crop. Since balances normally grow over time, taxing retirement money at its low point (contributions) rather than at its high point (distributions after decades of account growth), Roth accounts are more tax-efficient. But the deductibility of contributions to tax-deferred accounts allows savers to build larger retirement balances. It's a balancing act.
Control withdrawals. Since Roth IRAs aren't subject to RMDs, owners have control over distributions. Don't need the money in a given year? Don't withdraw any funds. The value of your Roth IRA declined? Keep your funds in the account and draw money from another account (cash? borrowing against permanent life insurance?) to pay your bills.
Diversity your tax risk. Savvy retirement planners understand the importance of diversifying their investments. Classes of assets - such as large company stocks, real estate, international stocks, and corporate bonds - perform very differently year-to-year. Diversifying smoothens the ride. Tax policy is subject to political forces, which may result in decreases in marginal tax rates (the 2017 Tax Cut and Jobs Act put personal income tax rates on sale through 2025) and proposals to raise rates). Retirement investors whose nest eggs are held in tax-deferred accounts only may find tax rates applied to their distributions that are very different from what they envisioned. Placing a portion of retirement savings in Roth accounts results in tax certainty, as income taxes are levied on contributions, when the applicable tax rate is known, and not on future withdrawals when rates aren't yet established.
Entering the Roth Back Door
What is a back-door Roth funding strategy? The opportunity to fund a Roth IRA is restricted based on income. For example, a couple filing taxes jointly with an adjusted income greater than $208,000 can't contribute to a Roth IRA - even if they're willing to pay taxes on their contributions and thus fund federal and state government current expenses.