Many investors opt to put a portion of their earnings into a Roth IRA in order to benefit from the potential tax-deferred earnings as well as tax-free withdrawals available during retirement. Both are made possible by the fact that a Roth IRA is funded by after-tax dollars. The fact that, as of this writing, Roth IRAs are not subject to minimum annual withdrawals - unlike traditional IRAs - is also a compelling factor for many people. These fundamental components of Roth IRAs may make them appealing to individuals who are interested in long-term tax planning.
However, if you make more than $133,000 per year (again, as of this writing) or you and your spouse collectively earn more than $196,000, you are prevented by current tax law from directly funding a Roth IRA. And if you have already looked into a Roth, you may have already decided that this type of retirement account is consequently off the table for you and your family. (For more, see: The Basics of Roth IRA Contribution Rules.)
Backdoor Roth conversion
If that is the case, you may want to think again. Thanks to relatively recent tax law changes, there may be a way for you to access the benefits of a Roth IRA despite your generous salary.
This is where a critical aspect of the Roth IRA income limit comes into play - the fact that your income may prevent you from directly funding a Roth. While you cannot simply invest in a Roth IRA with your after-tax dollars if your earnings exceed the legal threshold, you may have the option of converting funds invested in a traditional IRA into a Roth. Thanks to an IRS rule that took effect in 2010, there are currently no income limits on converting traditional IRA funds into a Roth, enabling some investors to execute what is known as a backdoor Roth conversion. Despite the dubious phrasing of that colloquial term, such conversions are entirely legal and depending on your financial plan, they could offer advantages that a traditional IRA may not.
If you are like many individuals with high salaries, you may already be contributing the maximum allowable amount of your income to the 401(k) plan offered by your employer. In 2016, the limit for these contributions was $24,000 for individuals 50 years of age or older. For many reasons, you may want to be able to save more money for retirement than $24,000 per year - for example if you want to take advantage of your current salary due to insecurity about the long-term prospects of the industry you work in or if you are getting closer to retirement and want to build up your investments more than you have in the past. You may also be interested in having more tax-free funds available when you do retire or in funding your retirement account with money taxed at your present rate. If any of the above applies to you, a backdoor Roth conversion may be worth looking into. (For more, see: Is a Backdoor Roth IRA Suitable for You?)
Steps to Take
An individual looking to take advantage of this strategy would first need to open a post-tax traditional IRA. In the case of married couples, both partners could do so. Non-deductible IRAs are available to anyone, even if they are already contributing to their employer’s 401(k) plan and contributing the legal maximum. Presently, the limits on contribution levels to a non-deductible IRA are $5,500 per year for individuals under 50 and $6,500 for those 50 or older. Married couples, if both partners are 50 or over, can contribute up to $13,000 jointly each year. In this hypothetical scenario, we are assuming that the individual involved does not already have a post-tax IRA in place, and would be setting one up anew for the purposes of a backdoor Roth conversion.
Once this step is in place, the next would be to convert the traditional IRA to a Roth IRA. If you are setting up an after-tax IRA for the first time, the speed with which this account can be converted to a Roth should be considered carefully, and this is an excellent time to consult with your fiduciary advisor and/or tax professional. You may owe relatively minimal taxes if your account can be converted quickly, although this is a general rule and not necessarily true in all cases. The more time that passes between your initial contribution to a traditional IRA and the conversion of that account to a Roth, the higher the likelihood that the funds in your traditional IRA will generate a financial gain and thus a tax liability on these gains, if any.
Once a backdoor Roth IRA conversion is complete, funds in the Roth account will not be subject to taxation upon post-retirement withdrawal and this tactic can be employed annually to grow the value of the Roth IRA using funds originally contributed after taxes to a traditional IRA. For some investors, this may be an appropriate strategy for retirement planning, but it is not necessarily for everyone.
Since there are many variables at play in a backdoor Roth conversion, and no one strategy is right for every investor, consulting with your tax attorney or financial advisor before making a move like this is a great idea. While backdoor Roth IRA conversions may be an option for you, it is worth noting that scenarios exist that may make this tactic less appealing.
Things to Consider
If you already have an IRA funded with pre-tax money, for example, you will owe taxes on those funds when you convert them to a Roth. This may influence your decision, and it is best to have all of this information available to you before making a change in your retirement plan or investment strategy. If incorporating backdoor Roth IRA contributions does become part of your long-term plan, the money you put into your Roth will not be subject to taxation on any potential gains nor will your withdrawals during retirement be subject to taxation. If you are earning a high salary now and do not have an IRA set up, a backdoor Roth conversion strategy may be worth considering as you look at all of the options at your disposal with the help of your fiduciary advisor.
If you would like to learn more about how a backdoor Roth IRA strategy could play a role in your retirement plan or investment portfolio, contact your financial advisor. It’s never too early to start planning for a comfortable retirement on your own terms. (For more from this author, see: Understanding the Benefits of Rollover IRAs.)