First made available to investors in 1998, Roth IRAs introduced a whole new structure for tax-deferred saving. Until then, investors could make tax-deductible contributions to traditional IRAs and 401(k)s. Roth accounts allowed tax-free distributions.
Many of our clients want to take advantage of both ways of saving for retirement.
The problem: Roth accounts have income limits.
In 2013, single filers making more than $127,000 in adjusted gross income, and married couples making more than $188,000, are not allowed to contribute to Roth IRAs.
The question: If I – or my spouse and I – are above the income limits for Roth IRAs this year, can I still Roth?
The answer, fortunately, is yes…if you know how.
Option 1: A Roth 401(k)
As I wrote in my earlier post on Roth 401(k) accounts, there are no income limits barring participation in Roth 401(k) programs. If your company offers it, you can take advantage of it.
Roth 401(k) accounts have the same contribution limits that their traditional 401(k) cousins have: a generous $17,500 for 2013 ($23,000 if you are over 50).
Unlike contributions to traditional 401(k) accounts, contributions to a Roth 401(k) are not tax deductible. However, when you leave the company, you can roll over your Roth 401(k) into a Roth IRA and pay no additional taxes.
One side note for the self-employed and entrepreneurs: A number of investment companies, like Vanguard, offer Individual Roth 401(k)s. (These services advertise a total contribution limit of $51,000 in 2013, which includes both employer and employee contributions. Employee contributions are limited to the same $17,500, just as they are in a corporate 401(k). All employer contributions must be made into a traditional 401(k) account.)
Option 2: The Backdoor Roth IRA
A small handful of our clients might benefit from using a “backdoor” Roth IRA; some young people use the backdoor Roth IRA option every year, because they’ve decided that the advantages of the Roth (the tax-free distributions) outweigh the issue I’m about to outline below.
There is a catch to a backdoor Roth IRA: The IRS aims to tax some of the money you convert.
The concept for the backdoor Roth IRA emerged inauspiciously a decade ago. In 2003, the IRS began to phase out the Roth IRA income limit for people who wanted to convert their old, traditional IRAs into the new Roth format. Previously, people who could not make contributions to a Roth IRA because they made too much money, also could not convert a traditional IRA to a Roth IRA.
By 2010, the contribution limit was phased out completely. Since then, there has been no income limit for taxpayers who want to convert their traditional IRAs to the Roth format.
Thus, the backdoor Roth IRA was born.
Put simply, if you are over the income limit to open or contribute to a Roth IRA, you can still open a traditional IRA and then convert it to a Roth IRA. (It’s assumed that you will not attempt to take a tax deduction on the initial contribution to the traditional IRA, since you are also above the income limits for taking that deduction.)
Voila. Roth IRA.
Seems too good to be true? Well, it is, at least if you already have a traditional, deductible IRA. When you convert from a traditional IRA to a Roth IRA, the amount you convert is taxed by the proportion of all of your traditional IRAs funded by pre-tax contributions.
Let’s say you have a traditional, deductible IRA valued at $10,000, and this year you plan to contribute $5,000 to a traditional, non-deductible IRA to convert to a Roth account.
The way the IRS looks at it, you have $15,000 in IRA assets, 66.7% of which are deductible.
If you convert the $5,000 account to Roth, the IRS will require you to pay taxes on 66.7% of that amount, or $3,333.
Given the complexities, if you have existing traditional IRA assets, consider the tax consequences carefully. You should consult with a tax accountant about your particular situation before pursuing a backdoor Roth IRA.
So, Do You Want to Roth?
We believe having a balance of Roth and traditional retirement assets gives you more flexibility in managing your taxes in retirement.
Thanks to the Roth 401(k) and Roth IRA conversions, individuals fortunate enough to have high income this year still have options to acquire and build Roth assets.