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Locked Out of the Roth? Try the Backdoor Roth IRA

by smeneshi - Mar 26, 2015

Many of you in the public sector have a household income that disqualifies you from making contributions to the popular Roth IRA.  For married couples with a Modified Adjusted Gross Income (MAGI) of $193,000 or more, contributions to a Roth IRA are not allowed.  For those of you who earn $131,000 or more, file as single, head of household, or married filing separately and did not live with your spouse at any time during the year, you’re also disqualified from making Roth IRA contributions.   That’s the ckdd news.

The good news is there’s a little-known and infrequently used IRS tax-loophole that allows those of you that have a MAGI above the aforementioned limits to still contribute to the Roth IRA.  It’s unofficially called the “Backdoor Roth IRA” and it’s something you might want to consider because of the huge tax benefits the Roth offers: tax-free distributions of your earnings on qualified withdrawals* and no Required Minimum Distributions at age 70 1/2.  You’ll also want to consider this type of contribution because of the  higher taxes many of you in the public sector are potentially setting yourself up for.

HERE’S WHY THE ROTH IS SO BENEFICIAL

There are three types of retirement account contributions: deductible (pre-tax), non-deductible (after-tax) and Roth.  Pre-tax contributions to a Traditional IRA or 457(b) deferred comp plan grow tax deferred, but ordinary income taxes are due (and possibly a penalty except for the 457(b) plan) when you make withdrawals.  Non-deductible (after-tax) contributions to a Traditional IRA can be withdrawn without taxation, but earnings are taxed when you make withdrawals.  Conversely, qualified withdrawals from a Roth IRA are tax-free and contributions can be withdrawn at any age without tax or penalty.  Also, since you don’t have to take Required Minimum Distributions after the age of 70 1/2, you can pass the Roth onto your kids and let them take distributions over their lifespan.

Backdoor Roth IRA

HERE’S HOW THE BACKDOOR ROTH IRA WORKS

If the benefits of the Roth IRA are enticing enough, but your income is too high to directly contribute to one, the Backdoor Roth IRA is your solution.  The first step to doing a Backdoor Roth IRA is to make a non-deductible contribution to a new Traditional IRA account.  The word “new” is very important as you’ll soon find out why.  Once the funds clear, you then contact your plan custodian and direct them to convert your newly-established Traditional IRA to a Roth IRA.  And that’s about it…there’s not much to the mechanics of doing a Backdoor Roth conversion, but before executing this strategy, it’s highly advisable to consult with an experienced tax advisor or Certified Financial Planner™ practitioner who is familiar with the Backdoor Roth because there could be some severe tax consequences.  If you have no other existing IRA accounts, you’re in the clear as far as taxes on the conversion are concerned.  But there will be tax consequences if you have other existing IRA assets such as a Traditional IRA, a Simplified Employee Pension or a SIMPLE IRA where you took a tax deduction.  You’ll have to aggregate the account values of these IRAs to calculate the tax owed on your new Backdoor Roth conversion.

For example, let’s say you and your spouse have a Modified Adjusted Gross Income that precludes you from making contributions to a Roth IRA, and you have $95,000 from a Traditional IRA that you rolled pre-tax money into from an old job.  If you make a $5,000 contribution to traditional non-deductible IRA for purposes of taking advantage of the backdoor conversion, the taxes you’ll owe on the conversion will depend on the percentage of taxable versus non-taxable assets in all of you IRA accounts, not just the new one you opened.  So in this case, since $95,000 of your deductible IRA assets haven’t been taxed yet and your new non-deductible IRA contribution of $5,000 already has been, 95%, or $4,750, of your $5,000 contribution would be taxable upon the conversion.  Ouch!

If you have no other existing IRA accounts, then the Backdoor Roth IRA could be a very helpful tool in helping you reduce future income taxes.  Again, please consult with a tax advisor or Certified Financial Planner™ practitioner who is familiar with the Backdoor Roth conversion.  If you do have other IRA assets but still want to do a Backdoor Roth, you can transfer those IRA assets into your 457(b) or 401(k), effectively ‘eliminating’ these assets currently being held in an IRA.  If you go this route though, remember that plan administration and investment fees could be higher in your 457(b) or 401(k) plan, so proceed with extreme care.

 

Please consult your tax professional before making any changes that could affect your tax situation.

Securities and advisory services offered through Ausdal Financial Partners, Inc.  Member FINRA/SIPC 5187 Utica Ridge Road Davenport, IA 52807    563-326-2064  www.ausdal.com.  Public Retirement Planners, LLC and Ausdal Financial Partners, Inc. are separately owned and operated.

 

 

 

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