Written by: Erich Imphong, CFP®
Once you understand the differences between a Traditional and Roth IRA, (see our recent blog: Which Is The Better IRA Fit: Traditional or Roth?), you will know whether a Roth IRA is beneficial for you or not. Many people would like to take advantage of a Roth, but can be frustrated by the restrictions that the tax law imposes on availability. There may be a solution.
In 2010, the IRS removed the income limit on Roth conversions, which inadvertently created a loophole for high-income earners to fund Roth IRAs via the backdoor Roth IRA strategy. Specifically, if your earned income is too high in that it is over $129,000 if you’re single or $191,000 if you’re married filing jointly, you may want to capitalize on this strategy in order to participate in the benefits of Roth IRA’s – tax-free withdrawals on earnings in retirement along with no required minimum distributions.
The mechanics of the backdoor Roth are relatively straightforward in that you can fund a Traditional IRA with after-tax dollars and convert these funds to a Roth IRA. Any gain on funds in the Traditional IRA will be taxable in the conversion. It is for this reason that you should analyze gains in the traditional IRA ahead of considering the conversion. Regular IRA funding rules still apply to this strategy in that you are limited by the current year’s contribution limits, and that contributions for the prior year must be done by April 15 of the current year.
The backdoor Roth IRA is best utilized by high-income earners that do not have any other deductible IRA’s or Traditional IRA’s with significant account appreciation. The IRS views your Traditional IRA’s in aggregate, and this means the amount you convert to the Roth is taken as a percentage over the total amount you have in all your Traditional IRAs. Therefore, the silver lining for retirement saving procrastinators is they can capitalize on this current IRS loophole.
However, if you have a larger Traditional IRA with considerable gains, you are not necessarily precluded from the backdoor opportunity. That said, it may be worth examining the tax impact of strategically converting portions of your Traditional IRA to a Roth over time if you do not expect your tax bracket to change significantly in retirement. Put simply; pay the tax now so you don’t have to pay it later. Also, it is important to note that the IRS only identifies conversions per taxpayer. This means that if you’re married with no IRA and your spouse has a large Traditional IRA, you will not be taxed with your spouse’s IRA on a conversion if you elect to do the conversion.
Will It Last?
Included in this year’s budget proposal for the US Government are many tax matters that could be both beneficial and frustrating to taxpayers. These tax proposals are summarized in the “Treasury Greenbook.” One of the proposals addresses the aforementioned backdoor Roth loophole. Specifically, the proposal would permit amounts held in a traditional IRA to be converted to a Roth IRA only to the extent a distribution of those amounts would be includible in income, and non-deductible contributions to Traditional IRAs will not be permitted to be converted to Roth IRAs. However, regardless the outcome of the proposal, one should still consider the long-term benefits of the Roth IRA.
Decisions regarding Roth IRA conversions can be complicated and confusing. At GAM, we are available to discuss all of your options and assist you in any way. Please give us a call.