ROTH IRAS ARE A POWERFUL WAY TO SAVE FOR RETIREMENT
Contributions into a Roth IRA are not tax deductible. However, the earnings in the account accumulate tax deferred, and can be distributed completely tax free after age 59½, provided 5 years have elapsed since the tax year of your first Roth contribution. Many investors who might otherwise contribute to a Roth IRA find themselves constrained by the IRS income limits which restrict their ability to contribute to a Roth IRA based on their adjusted gross income (AGI).
For tax year 2017, single individuals who have AGI of more than $118,000 will have their ability to make Roth contributions phased out until they are completely disallowed with an AGI of $133,000 or higher. Married couples who file jointly are restricted based on an AGI range of $186,000 – $196,000. Are these higher income investors out of luck when it comes to the Roth IRA? The answer: no, not necessarily.
Based on the IRS rules, which allow for conversions of Traditional IRAs into Roth IRAs, higher income investors still have the ability to contribute to a Roth IRA through a tactic called the “Backdoor Roth IRA.” The Backdoor Roth allows investors to make a non-deductible contribution into their Traditional IRA (non-deductible IRA contributions have no income restrictions), and then convert this amount into a Roth IRA. The IRS does not currently have an income limit restricting the conversion of traditional IRAs to Roth IRAs. Therefore, regardless of how much income an individual or married couple have, they still have the ability to place money into a Roth IRA account, albeit with a few more steps. There are, however, several important caveats to be aware of.
This method works best when you do not currently have any assets in a traditional IRA or IRA Rollover account. When this is the case, non-deductible IRA contributions are made to a traditional IRA and then immediately converted to a Roth IRA. This will constitute a tax free conversion. This makes sense; you don’t take a tax deduction for your contribution into an IRA, therefore you don’t owe tax on that amount when you convert. You can still do a “Backdoor Roth IRA” if you have balances in a Qualified Retirement Plan like a 401(k), Profit Sharing Plan or 403(b) Plan. The rules get more complicated and the strategy less beneficial if you currently carry a balance in a traditional IRA or IRA rollover account. For the purposes of this article, we will limit the discussion to only investors who have no other Traditional or Rollover IRA assets, as the discussion for what happens when you have other IRA assets is too lengthy for an article.
For 2017, the contribution limit to a Traditional or Roth IRA is $5,500 for individuals under age 50, and $6,500 for individuals 50 and older. This is the maximum amount that may be contributed in any given tax year per individual. However there is no maximum amount that can be converted to a Roth at any given time. This is an important distinction between contributions and conversions. Investors who are looking to shift more funds into a Roth IRA can simply convert the assets they currently hold in their Traditional IRA accounts. This will generate taxable income on any before-tax amounts or appreciation that is converted, but will not be subject to the 10% penalty for early IRA withdrawals. If an investor is willing to pay the taxes, they can shift money into the Roth IRA well in excess of the annual contribution limit.
Overall, a Backdoor Roth IRA contribution can be a great way for higher income earners to contribute to a Roth IRA where they otherwise would be ineligible based on their adjusted gross income. The decision to convert other IRA assets that will result in additional taxable income is a personal one. It will depend on your age, the amount of the conversion, and most importantly, your marginal tax bracket. All investors who are considering a Roth IRA conversion should consult with their advisors as well as their CPA’s to determine if a conversion is in their best interest.
Tom Reynolds, CPA & Matt Reynolds CPA, CFP®
Co-Managing Partners, CRA Financial
Francis C. Thomas CPA, PFS,
Robert T. Martin, CFA, CFP®,
This article is for informational and educational purposes only and should not be relied upon as the basis for an investment decision. Consult your financial adviser, as well as your tax and/or legal advisers, regarding your personal circumstances before making investment decisions.