There is a maximum income limit for contributing to a Roth IRA: You cannot contribute to a Roth IRA if your income is over about $200,000 MFJ or $135,000 MFS. If you are prohibited from contributing to a Roth IRA because your income (Modified Adjusted Gross Income, or MAGI) exceeds $200,000, then the good news is at least your MAGI exceeds $200,000. A good problem to have, in a way.
Backdoor
However, there is a way around the income limit, and here is how it works:
- Make a non-deductible (meaning that you make the contribution with after-tax funds) contribution to a Traditional IRA, which doesn’t have an upper-income limit;
- Convert it at any point after you make the contribution into a Roth IRA. This will involve setting up a separate account at the broker or bank where you have your IRA.
- Pay a tax, if any, on the conversion amount.
Is it legal?
Yes, it is, affirmatively so by the new 2018 Tax Bill, according to this article in a recent issue of the Investor’s Business Daily. If this “backdoor” method is legal, then why doesn’t the IRS just get rid of the upper-income limit for the Roth IRA? That’s a great question! Here is another link to the IRS website that compares Traditional vs. Roth IRAs – very useful.
Roth Advantages
Both Roth and Traditional IRA’s grow tax-deferred as long as the money remains in the account. The main advantage of the Roth IRA is that the money that you withdraw from a Roth IRA, once you are over 59 1/2 years old, is tax-free, as long as you have held the account for at least 5 years. Contrast that with a Traditional IRA, withdrawals from which are taxed as ordinary income. Who wants to pay taxes when they are retired and living off of money they have saved over the years? A Roth structure is the way to accomplish tax-free money.
An additional advantage of a Roth IRA is that there is no Required Minimum Distribution or RMD. Perhaps you think, “I have saved this money all of my life – of course I will want it when I get older!” However, as they say, Stuff Happens, and RMD issue can become significant if you are trying to avoid or defer paying taxes for as long as possible. With a Roth structure, you can avoid any RMD. Maybe you can pass this money down to your heirs – there are rules for distribution in that case, but it will be your heirs’ problem.
Another Tactic
Think about using outside funds to pay any taxes you incur when you do a backdoor or conversion Roth. Just because you owe taxes on a conversion doesn’t mean that you have to pay those taxes from your retirement funds. If you have enough outside money, then think about using some of it to pay your conversion taxes so that you can keep 100% of your retirement money growing tax-deferred in your new Roth account.
Tax Bracket Arbitrage
Optimally, you should backdoor or convert to a Roth during a year when your tax bracket is lower. This may be difficult to do if you are in your prime earning years and your income continues to go up. Why add to your tax bill if it is already too high? However, I look at it a different way: When you retire, the last thing you want to worry about is having to pay more taxes. It may be better for your mental wellbeing to pay more taxes while you are working so that you can enjoy tax-free income from your Roth when you are retired. It may not make economic sense but it may make perfect lifestyle sense.
Contact a Planner
I competent Financial Planner can help you think through all of these issues. Please contact me if you are giving thought to Traditional vs. Roth IRA’s.