AGI too high for a Roth contribution - maybe a Backdoor Roth is for you
Roth IRAs have become very popular as a retirement savings vehicle. There are a few ways to get money into a Roth IRA, but we are going to look specifically at a technique known as the ‘Backdoor Roth.’
Roth IRAs appeal to many people because of the many benefits they offer. They were established with the Taxpayer Relief Act of 1997. The basic premise is as follows:
1) ANYONE with earned income below certain adjusted gross income (AGI) thresholds may contribute to a Roth IRA.
2) Contributions to a Roth IRA are made with after-tax dollars. Unlike traditional IRAs, you cannot take a deduction for Roth contributions.
3) A Roth IRA is a tax-deferred vehicle. Earnings and appreciation are not taxed currently.
4) If the account-owner satisfies certain requirements, then the distributions come out TAX-FREE! In order to qualify for the tax-free distributions, the account-owner must have had a Roth IRA for at least 5 years, AND be at least age 59 ½, whichever is later. The account-owner can always withdraw contributions, which come out first.
5) Unlike traditional IRAs, where the IRS comes knocking at age 70 ½ for you to begin withdrawing funds in the form of required minimum distributions (RMDs), a Roth IRA accountholder NEVER has to take distributions.
Here’s the catch - not everyone can contribute to a Roth IRA. As I just mentioned, there are limits based on AGI. In 2014, those who file as married filing jointly (MFJ) may contribute if their AGI is less than $191,000. For single filers, the AGI limit is $129,000. The maximum contribution for 2014 is $5,500. If you are age 50 or better, you may make a catch-up contribution of another $1,000. If your AGI is between $181,000 - 191,000 for MFJ ($114,000-129,000 for Single), then your contribution will be reduced.
Now that we’ve laid the groundwork, let’s look at the Backdoor Roth contribution. Here’s the key - the limits on traditional IRA contributions relate to deductibility of the contribution, not whether you can contribute. Anyone with earned income (who is under age 70 ½) may contribute to a traditional IRA. So an individual with income in excess of the AGI limits to contribute to a Roth IRA makes a contribution, instead, to a traditional IRA. The contribution is in after-tax dollars. Once the contribution is in the traditional IRA, the account-owner proceeds to convert the IRA balance into a Roth IRA. The after-tax contribution moves into the Roth IRA, virtually replicating a contribution to the Roth.
The only way this strategy works is if the account-owner does not have any other IRAs. The IRS views all IRAs as one bucket of money. For those with self-employed plans, SEP IRAs are included in that bucket. Once pre-tax dollars are present, then there will be a taxable distribution as part of the conversion. For example, let’s say I set up a traditional IRA and make a $5,000 non-deductible contribution to it in 2014. I then convert that $5,000 over to my Roth IRA.
Looks good, right? No so much, because I have a SEP IRA with $10k in it. From the IRS’s perspective, I have $15,000 in IRAs, not $5,000. The SEP IRA balance will be included in the calculation to determine how much tax I have to pay on the conversion. Since 2/3 of my IRA funds are pre-tax, 2/3 of my Roth conversion will be taxable too. Ouch!
So what’s the moral of the story? If the Backdoor Roth strategy appeals to you, get tax advice first!
Kristine d’Esterhazy is a Certified Financial Planner® practitioner with PARAGON Wealth Strategies, LLC in Jacksonville, Florida.
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