Roth IRAs are becoming increasingly popular savings vehicles as investors realize their utility in securing long-term financial goals as well as their availability to fund shorter-term financial goals, such as a first time home purchase or to help defray the cost of a child’s college education.
Unfortunately, due to income tax rules and regulations, high-income earners are not eligible to contribute to a Roth IRA. The ‘backdoor’ Roth IRA conversion may resolve this problem and make this dynamic savings vehicle available to nearly everyone.
What's so special about a Roth IRA?
A traditional IRA may or may not allow for a tax-deductible contribution based upon your circumstances but the appreciation and earnings grow tax-deferred until the funds are withdrawn. In contrast, contributions to a Roth IRA are never tax-deductible but the earnings grow tax-free. Consequently, when you withdraw your money from a Roth, you pay no income taxes at all whereas withdrawals from a Traditional IRA are taxed as ordinary income at the taxpayer’s marginal income tax rate.
Similar to a traditional IRA, you can initiate penalty-free withdrawals from a Roth at age 59½, as long as you’ve held your Roth account for five years. You are also allowed to withdraw your own contributions at any time (after a five year holding period), tax- and penalty-free.
One could argue that the current tax deduction for a traditional IRA contribution can be more valuable than future tax-free withdrawals from a Roth IRA. However, a Roth’s tax-free income in retirement can actually lower your overall taxes in several ways - not only increasing your cash flow, but also extending your retirement capital further into the future. Here’s how it works:
- The tax-free income will not push you into a higher tax bracket, unlike taxable withdrawals from a traditional IRA.
- The tax-free income will not count towards the “stealth” IRMAA Social Security tax on excess earnings.
- There is no required minimum distribution rule for a Roth IRA, meaning you can keep growing your retirement capital tax-free and potentially leave it to your beneficiaries to continue growing tax-free.
- A Roth IRA is your insurance against future tax increases. You may expect your tax bracket to be lower when you retire (which could justify taking current tax deductions on a traditional IRA); however, in the current political environment chances are tax rates will increase. A Roth IRA protects you from this.
The contribution limits for a Roth are the same as a traditional IRA: up to $6,000 in 2019 or $7,000 if you are 50 or older. However, if your income exceeds $122,000 ($193,000 for joint filers) in 2019 you may only make partial contributions and no contributions are allowed for incomes over $137,000 ($203,000 for joint filers).
If your income exceeds the limits, you can always gain access to a Roth through the ‘backdoor’.
How does the backdoor Roth conversion work?
The tax code includes a loophole that allows individuals, who otherwise don’t qualify for a Roth IRA, to fund a traditional IRA and then convert it into a Roth. There is no limit on income or on how much or how many times you convert as long as the transactions are not deemed to be re-conversions under IRS guidelines.
The only hitch is that when you do convert, it triggers a tax on the conversion amount - because it is treated as a distribution from your traditional IRA.
For example, if you contribute $6,000 to a traditional IRA and then transfer it to a Roth, that amount is added to your adjusted gross income (AGI) and taxed at your federal tax rate. The key is to convert just enough to avoid pushing your AGI into a higher tax bracket.
You can also convert existing assets from a traditional IRA without limitations. If you have $100,000 in a traditional IRA, it can all be converted at once. In terms of taxes though, it may be better to convert a percentage of your total IRA funds over several years.
For Roth IRA conversions, there's possibly no time like the present.
Thanks to the Tax Cuts and Jobs Act, your current federal tax rate may be the lowest you’ll see in your lifetime, which is why converting to a Roth now could make sense. Also, it could be worth taking advantage of the conversion option before Congress considers legislation to remove this valuable planning tool.
As straightforward as a Roth IRA conversion may seem, it is fraught with potential hazards if you don’t follow the rules strictly. You still have time to consider a Roth conversion this year, but you should seek the assistance of a qualified tax advisor to help you develop your strategy. Click the button below to schedule a free consultation.