So you make too much money to qualify for a Roth individual retirement account. What if you still want to have sources of tax-free income in retirement, which is what a Roth gives you? I present the backdoor IRA, a way to establish a Roth despite the income limits.
If your adjusted gross income ( AGI ) exceeds $131,000 (for single filers) or $193,000 (for couples), you cannot contribute to a Roth IRA directly. To get around this, you fund a traditional IRA, and then convert the money into a Roth.
Back in 2010, the Internal Revenue Service made a very significant change to the rules governing conversions of traditional IRAs to Roth IRAs. It eliminated the AGI limits. Anyone can make such a conversion, which opened the backdoor to a Roth IRA for higher income earners. Here's how it works.
Regardless of AGI, you can contribute $5,500 to a traditional IRA in 2015, along with an additional $1,000 if you are over 50. If your AGI is above the phase out limits , your contributions are non-deductible. For instance, if you are married to someone who has a 401(k) and you have a joint AGI of at least $183,000 yearly, your ability to deduct traditional IRA contributions phases out between that sum and $193,000.
A non-deductible traditional IRA has some tax advantages. Earnings on your investment grow tax deferred, although not tax free. After you reach 59½, your withdrawals are taxed proportionately, affecting earnings.
The big benefit of a Roth is that earnings are also tax-free. Instead of just your tax basis (what you originally contributed, after tax), the total distribution is off limits to the IRS.
When you make the conversion, you don't owe any taxes on your contributions - you already paid the taxes on that portion of your annual IRA investment. You do owe taxes on the earnings, though, just as if you take a withdrawal from your account. But most IRA custodians don't have a waiting period for a conversion. You can do it shortly after the money arrived in the account, when the amount of earnings is very small, if any. That means the amount of taxes you owe will be very small, as well.
So, for the small amount of taxes you pay to convert the earnings, you now, through the backdoor IRA, make a Roth IRA contribution for the year. Those converted dollars are like any other Roth IRA contributions, growing tax-free while they remain invested. And at retirement, you can withdraw money with no taxes at all.
If you start to wonder how the IRS would offer this opportunity without a catch, your instincts are right. There is one. When deciding the taxable portion of a Roth conversion, the IRS uses the sum of all your IRAs. This is called the pro rata rule.
In the scenario above, the only money in the traditional IRA was the non-deductible contribution. In that case, things are straight forward. But what happens if you have pre-tax money in your IRA, either from previous deductible contributions and earnings, or maybe an old 401(k) that you rolled into it?
The IRS wants its taxes. If you have pre-tax money out there, no matter how many IRAs they are spread over, the IRS considers them all, for the sake of Roth conversions.
Here is an example: You make a $5,000 non-deductible contribution to an IRA this year, with the idea that you are going to carry through with the backdoor Roth. You also have another $95,000 from an old 401(k) that you rolled into an IRA after you changed jobs.
You have a total of $100,000 in IRA assets. The $5,000 you intend to convert is only 5% of that, so only 5% of the conversion, or $250, is tax-free. Instead of making a tax-free Roth conversion on the $5,000, you actually owe taxes on $4,750.
To climb Mount Everest, you need a Sherpa. A Roth conversion is like climbing a dangerous mountain. Without a guide, you risk lots of pitfalls. The cost of getting it wrong may outweigh any gains you hope to make. This is definitely one of those situations when you want to engage the assistance of a qualified financial planner and likely a certified public accountant as well.
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Tim Long, CFP, CRPC, is a financial planner withHutchinson Financialin Little Rock and Bentonville, Ark., and in Texarkana, Texas.
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