Backdoor retirement strategies and tax implications

Retirement and tax strategy can often go together like the chocolate and peanut butter in a Reese’s peanut butter cup. However, it’s critical to understand the tax implications and the potential “gotchas” in financial planning for your clients. While squirreling away money for retirement can have tax consequences, some may involve current tax savings while others may involve exchanging higher tax bills for greater benefits when retiring.

The concept of backdoor retirement alternatives are often overlooked when holistically reviewing a client’s entire financial picture. Similar to the concept of a workaround, “backdoor,” in this context, is a moniker used to describe an alternative way to accomplish something.

As a practitioner, there is a balance to strike between minimizing a client’s tax liability while maximizing their retirement strategy. At times, these two aspects of financial planning are not in sync, so two financial products worth exploring are the Roth IRA and the Health Savings Account (HSA).

Roth IRAs

The Roth IRA was introduced in the Taxpayer Relief Act of 1997 by its namesake, Sen. William Roth, as an alternative to traditional IRAs. The Roth IRA is, for all intents and purposes, the opposite of the traditional IRA. While contributions to a traditional IRA allow the taxpayer to take a tax deduction on their tax return, a contribution to a Roth account is based on after-tax income and doesn’t allow this same tax benefit.

However, the good news is that in exchange for giving up this current tax benefit, the taxpayer enjoys a free ride on their taxes when withdrawing from the Roth at retirement. Sounds great? Maybe so. But here’s the deal. The Roth comes with an important condition: The taxpayer is subject to an income limit that sometimes prevents making a Roth contribution, especially for higher-income taxpayers.

Where does the backdoor come into play? There are three ways to establish a Roth when a taxpayer is above the income limit:

1. The taxpayer can establish and fund a traditional IRA, convert the funds into a Roth IRA, and pay the taxes on that conversion.
2. If a taxpayer has a 401(k) account from a previous employer, they can convert that account into a traditional IRA and subsequently convert again into a Roth IRA.
3. If a taxpayer is employed at a company that sponsors a 401(k) plan with a designated Roth account, the participant can contribute without being subject to any income limitation.

All of the above will allow a taxpayer to establish a Roth account. Keep in mind that taxpayers can convert traditional IRA funds to a Roth IRA account as many times as they wish, even if they are above the income limit for contributions.

Health Saving Accounts

The second backdoor option is to establish an HSA, a type of savings vehicle for setting aside pre-tax funds for paying for qualified medical expenses. Introduced as part of legislation enacted in 2003, the taxpayer sets up the HSA with a qualifying financial sponsor such as a bank or brokerage house. The funds in the account can be invested similarly to that of an IRA, for example, in mutual funds, stocks, or exchange-traded funds. As a result, the account also has the dual purpose of serving as an investment vehicle. In order to contribute to the HSA, the taxpayer must be enrolled in a high-deductible health plan.

The HSA qualified withdrawals serve to offset the cost of doctor visit copays, coinsurance bills, or prescriptions. If an HSA account holder withdraws the funds for non-medical expenses, similar to an IRA, there is a penalty, in addition to the regular tax, assessed on these withdrawals. 

Now here’s the skinny on how this type of account can be a backdoor retirement plan: The law allows an HSA account holder to use the funds for qualified medical expenses up to the age they qualify for Medicare, set at 65 years old. If an account holder has unused funds in that HSA account upon reaching age 65, those funds can automatically be distributed to the account holder without penalty, can be used for any purpose—medical or non-medical—and will be subject to ordinary income taxes similar to IRA withdrawals. You can only imagine a diligent investor who begins contributing annually at a young age would have the ability to accrue a significant balance over time.

Educate your clients

The two types of backdoor investment strategies described here serve to expand the tools available in a tax practitioner’s arsenal, broadening the variety of available retirement and tax planning recommendations. Used appropriately, these can differentiate your practice in being innovative and standing out. Continuous education is key to keeping your clients informed.