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The phrase “Don’t let the tax tail wag the dog” means that you should not prioritize taxes over more important matters, such as your financial goals or overall investment strategy. However, when it comes to retirement savings, taxes are an important consideration. One way to manage taxes while saving for retirement is through a Backdoor Roth IRA.

First, let’s review what a Roth IRA is. With a traditional IRA, contributions are made pre-tax, and taxes are paid upon withdrawal in retirement. With a Roth IRA, contributions are made post-tax, but withdrawals in retirement are tax-free. This can be especially beneficial if you anticipate being in a higher tax bracket in retirement than you currently are.

There are income limits for contributing to a Roth IRA. In 2021, single taxpayers with a modified adjusted gross income (MAGI) over $140,000 and married taxpayers filing jointly with a MAGI over $208,000 are not eligible to contribute directly to a Roth IRA. However, there is a loophole that allows high earners to contribute to a Roth IRA through a Backdoor Roth IRA.

To do this, you first make a non-deductible contribution to a traditional IRA. There are no income limits for contributing to a traditional IRA. Then, you convert the traditional IRA to a Roth IRA. This conversion will trigger taxes on any pre-tax contributions or earnings in the traditional IRA, but since you already paid taxes on the non-deductible contribution, that portion will not be taxed again.

It is important to note that if you have other traditional IRA accounts, this strategy may not be tax-efficient due to the pro-rata rule. This rule requires all traditional IRA accounts to be considered together when calculating taxes on a conversion. For this reason, it is best to consult with a financial advisor before making a Backdoor Roth IRA contribution.

In conclusion, taxes should not be the only consideration when saving for retirement, but they should still be part of the overall strategy. The Backdoor Roth IRA is a useful tool for high earners who are not eligible to contribute directly to a Roth IRA. Just be sure to consider the pro-rata rule and consult with a financial advisor before making this type of contribution to ensure it is the right move for your individual financial situation. Don’t let the tax tail wag the dog, but also don’t ignore the importance of tax planning when it comes to your retirement savings.