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Smart Tax Planning: The Back Door Roth IRA Conversion

Roth IRAs are an increasingly popular retirement vehicle in the U.S.  The account allows investors to make taxable contributions, which then grow tax free until pulled from the account.  Unlike traditional IRAs, Roth IRAs do not require minimum distributions at age 70 ½, and are not taxed when withdrawn at retirement age.  They also provide more flexibility to potential heirs down the road.

Roth IRAs do have contribution limits and income phase outs though, which are similar to traditional IRAs.  For 2015, eligible investors may contribute up to $5,500, or $6,500 if they’re over age 50.  Contributions can be made by anyone with earned income at least as much as their contribution, but not over specified limits.  For married couples filing jointly, the phase out is between $183,000 and $193,000 in adjusted gross income.  In other words, the couple may contribute $5,500 in 2015 if their AGI is between $5,500 and $183,000.  The $5,500 contribution limit is reduced for AGI between $183,000 and $193,000, and couples may not contribute to Roth IRAs at all if their AGI is above $193,000.  For single filers, the phase out is between $116,000 and $131,000.  For traditional IRAs, the phase out levels are the same for contributors who are not covered by workplace retirement plans, and lower for those who are.

Fortunately, direct contributions are not the only way to divert savings into a Roth IRA.  Investors may also roll over and convert traditional IRAs or old 401(k) balances into a Roth IRA.  However, since these accounts are made with deductible contributions, you must pay tax on the converted amount since Roth IRAs are tax exempt investment accounts.

High income earners with AGIs over the phase out limits may not make traditional contributions to an IRA.  They may however make nondeductible contributions of up to $5,500 ($6,500 if over age 50).  This is where the “back door” Roth conversion comes into play.  Nondeductible contributions to IRA accounts may be rolled over into Roth IRAs, and since the contributor has already paid tax on the contribution (nondeductible), only the gains are taxed when converting.  So, while high income earners may not be able to contribute directly to a Roth IRA, they can still convert their nondeductible contributions.  And if done the same day as a nondeductible contribution, there are no gains to tax.  This allows retirement savings to grow tax free, which is a very powerful tool.

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