The Roth IRA is popular once again. The new lower income tax rates make conversions to a Roth more favorable than they used to be. In addition, the low tax rates are set to expire in 2025, and there is an expectation that higher rates could be on the horizon. This also favors the Roth IRA, whose qualified distributions are income-tax free, unlike with a traditional IRA.
SEE ALSO: How 10 Types of Retirement Income Get Taxed
Income restrictions can stand in the way of some people from pumping money directly into a Roth IRA , as people are phased out when their incomes exceed the $199,000 threshold (2018 marrying filing jointly limit, or $135,000 if single). However, there are indirect ways to fund a Roth IRA. Here are three examples:
Strategy #1: Mega Backdoor Roth IRA
First, make the maximum contribution to a 401(k) plan, which may be much higher than you realize. In 2018 the maximum tax-deductible contribution to an employer's 401(k) is $18,500 per person per year, or $24,500 with a "catch-up" contribution if over age 50. However, you may be able to go beyond that. If allowed by the plan, you can make "after-tax" contributions of up to $36,500 (any company match would reduce this amount), bringing the total to $55,000 (or $61,000 with a "catch-up" contribution).
The following year, you can withdraw the after-tax contribution amount to a traditional IRA if your employer allows in-service non-hardship withdrawals. Once the money is in a traditional IRA, you can then convert into a Roth IRA. What this accomplishes is the ability to significantly increase your Roth contributions.
An Example of What This Would Look Like
Let's assume Bob is 55 and contributes the $18,500 plus the over-50 catch-up to his 401(k) for a total of $24,500. Bob has more room to save this year, because the kids are out of college and he has the cash flow. He would like to fund a Roth IRA because he likes the idea of some of his retirement income coming out tax-free, unlike his traditional 401(k), from which all his income will be income taxable upon withdrawal. However, Bob is phased out of directly funding a Roth IRA because his income is too high.
So, Bob gives the backdoor Roth IRA a try, given there are no income limitations with funding after-tax contributions in a 401(k). Bob saves an additional $10,000 in after tax-contributions in the same 401(k). With this $10,000 in after-tax contributions, Bob then makes an in-service distribution to a Roth IRA.
Bob continues to do this each year for the next five years, building up his Roth IRA. Had he only made direct contributions to a Roth IRA -- assuming he qualified from an income standpoint -- Bob would have been subject to the annual maximum of $6,500 (the $5,500 limit plus $1,000 for being over 50). But by taking advantage of this mega backdoor Roth IRA strategy, Bob almost doubled what he could have saved in a Roth IRA on a yearly basis.
Fast forward to retirement, Bob now has a pool of money in his Roth IRA that he can access tax-free -- unlike his traditional 401(k). This could help him keep his future income tax liability down. His Roth IRA is also not subject to the required minimum distribution rules, meaning he is not forced to take his money out at 70½.
What to Watch for with This Strategy
You need to ensure you have the liquidity necessary to pull this off. It doesn't make sense to sock away more money in a qualified plan if that dries up your liquidity and leaves you cash poor.
Putting more money in a retirement plan means more money locked up until 59½, which is the age at which you can make a withdrawal from a 401(k) without paying an IRS penalty (contributions to Roth IRAs can be withdrawn at any time, penalty-free and tax-free, but gains withdrawn before age 59½ are subject to penalty). People need to be comfortable with their cash flow to do this.
Also, you should evaluate other uses of your money besides an after-tax 401(k) -- like college funding, paying down the mortgage or other debt. All else being equal, if you can swing it, the mega backdoor Roth IRA is a tremendous way to supercharge your Roth savings.
Strategy #2: Backdoor Roth IRA
You can do this same strategy on a smaller scale by contributing to a non-deductible IRA. Individuals prohibited from depositing directly into a Roth IRA can deposit the maximum amount permitted ($5,500 under age 50 and $6,500 over age 50 for 2018) to a non-deductible IRA. The backdoor Roth IRA is completed by immediately converting the non-deductible IRA into a tax-free Roth IRA.
This strategy will work better if you do not have any existing traditional IRAs to avoid the pro-rata rule. That rule says that you must aggregate all your IRAs to determine how much income tax you owe when you convert. If you have no other IRAs and you open a $5,000 non-deductible IRA and then convert it, you only owe tax on the earnings, if any. By contrast, if you have a $95,000 traditional IRA (pre-tax contributions), and you convert a $5,000 non-deductible contribution to a new Roth IRA, the conversion would be 95% taxable. Be aware of this strategy if you have other pre-tax IRAs outstanding.
See Also: Roth or Traditional IRA: Which Works Better for You?
Strategy #3: Consider recharacterizing Roth conversions from 2017
This is another tax rate arbitrage opportunity, and time is limited if you want to take advantage. If you made a Roth conversion in the past and it did not result in a large gain, consider recharacterizing it (undoing it) and then subsequently converting it back into a Roth in 2018 at a presumably lower tax rate. Review all conversions you might have made in 2017 and see if it makes economic sense.
The clock is ticking, though. A Roth IRA conversion made in 2017 may be recharacterized as a contribution to a traditional IRA if the recharacterization is made by Oct. 15, 2018. But under the recently passed tax overhaul, a Roth IRA conversion made on or after Jan. 1, 2018, cannot be recharacterized.
Advantages to Converting to a Roth
- Lower tax rates
- Not subject to 3.8% net investment tax
- Could save considerable money in taxes in the long run
- Contributions (but not earnings) could be withdrawn tax & penalty free at any time, even if you're under the age of 59½
- No required minimum distributions at age 70½
Disadvantages to Converting to a Roth
- Upfront tax bill on the amount you convert
- Conversion could push you into a higher tax bracket
- Conversion could trigger other income subject to the 3.8% net investment tax
- Recharacterization of prior conversions has been eliminated as of Oct. 15, 2018
The Bottom Line
All in all, the Roth IRA remains a powerful financial planning tool. Given qualified withdrawals are income tax-free and there are no required minimum distributions, the Roth IRA can be a retiree's best friend. Plus, now more than ever there are opportunities to fund a Roth, like the back-door strategies mentioned above.
The real key is to have a plan, including how and where to save like the Roth IRA. It's the little things that add up over time. And to me that is the real value of working with a professional that can help you uncover the best use of your money. As I tell my clients, in financial planning there is no magical unicorn or holy grail, there are only simple, small strategies that, collectively, if executed properly, add up to real dollars over time.
See Also: How to Leverage a Backdoor Roth IRA
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
