Roth IRAs are an excellent way of diversifying your retirement savings. Most people have the vast majority of their retirement savings in some form of employee sponsored defined contribution plan such as a 401(k) or 403(b). These plans are often a savings of pre-tax money automatically deducted from an employee’s paycheck.
Once that employee decides to retire, they can start drawing from their nest egg and pay applicable federal and state taxes. Some 401(k)’s and 403(b)’s offer a Roth option where the employee’s defined contribution (or just a portion of it) can be first taxed then contributed.
The invested savings will appreciate tax free and when the employee is ready to retire, they can make withdrawals federal and state tax free. You can even withdraw your principal amount before you’re 59 ½ without the IRA’s 10% early withdrawal penalty, as long as you don’t withdraw any earnings (interest) within five years of your first contribution. Once five years have passed since your first contribution, you are then allowed to withdraw earnings (interest) tax free as well.
In order to contribute to IRAs (traditional and Roth), you must have earned income. One downside to Roth IRAs is that there
are income limitations on who can contribute to them.
In 2017, if your modified/adjusted gross income (MAGI) is $133,000 (single) or $196,000 (married; filing jointly), you are ineligible to contribute to a Roth IRA. If you are eligible, you may contribute only $5,500 ($6,500 if you are age 50 or over) to a Roth IRA. If your income is beyond these limits or if you would like to contribute more than $5,500 ($6,500 if you are age 50 or over) to a Roth IRA in a year, a Backdoor Roth IRA is your only option.
What is a Backdoor Roth IRA?
A Backdoor Roth is a conversion of Traditional IRA money to a Roth IRA.
You can make this conversion no matter how much income you earn and you can also roll as much money as you’d like from an existing Traditional IRA. If you are considering converting a substantial amount or all of your IRA, you should consult a financial advisor to see whether or not this makes sense.
There could be severe tax implications if you are converting
an IRA with a large balance due to the fact that the taxable amount that is converted is added to your taxable income and the regular income rate is applied to your total income. If the amount is large enough, it could raise your tax bracket for the year in which you do the conversion.
If you are currently over the IRS threshold to contribute to a Roth IRA and don’t own any other IRA’s, one useful loophole is opening and contributing to a non-deductible (no tax deduction) IRA and immediately converting it over to a Roth IRA.
By doing so, you are avoiding the IRA income limitations. You are still bound by the $5,500 ($6,500 if you are age 50 or over) annual contribution limits but it still allows you to start building a nest egg of post-tax retirement savings.
This strategy could be used if you don’t have access to an employer-sponsored retirement plan such as a 401(k) or 403(b) or if you do, but the plan doesn’t offer a Roth option.
Converting your retirement savings from pre-tax to post-tax can be tricky and could have significant tax implications. Your best bet is to see a financial advisor to explore all your options and to see what makes the most sense for your unique financial situation.