High earners who would otherwise be excluded from contributing to a Roth IRA may want to consider this strategy.
If ever there were a tax-efficient saving vehicle, it is the Roth IRA. It can:
Provide you with the double benefit of tax-free growth and tax-free withdrawals in retirement
Is not subject to Required Minimum Distributions (RMDs)
Remains tax-free even after it is passed on to the next generation
For many higher-income individuals and families, however, contributing to a Roth has not been an option. But a rule change back in 2010 regarding Roth conversions introduced a potential door for them as well: the “back-door” Roth IRA contribution.
How the Back-Door Roth Contribution Works
To make a back-door Roth IRA contribution, you make a non-deductible contribution to your Traditional IRA. (In 2014 and 2015, you can contribute up to $5,500 per year; $6,500 if you are 50 or over and in 2013, you can contribute up to $5,500 per year; $6,500 if you are 50 or over.) You then immediately convert it to a Roth IRA.
Usually, a Roth conversion creates a taxable event. But in this case, because the balance in the IRA resulted from a non-deductible contribution, there is no tax due on the conversion. In other words, if properly executed, the back-door Roth is identical to a regular Roth IRA contribution.
Is a Back-Door Roth Worth It?
As we’ll describe in a moment, not everyone will be able to take advantage of the backdoor Roth IRA contribution. But if you can, the potential benefits can be significant. Especially if you can contribute annually for a number of years, the savings can really add up.
Are You A Candidate for a Back-Door Roth?
In general, you can use the back-door Roth IRA strategy if you meet these three conditions:
You are not eligible for a direct Roth IRA contribution because of income limitations. (In 2014, the income threshold is $181,000 for a married couple and in 2015, the income threshold is $183,000.)
You and/or your spouse participate in an employer plan such as a 401(k), and therefore are not eligible for a deductible IRA contribution;
You have no other pre-tax IRA assets — or you are willing to eliminate them. This includes pre-tax balances in accounts such as Traditional IRAs, Rollover IRAs, Simple IRAs, or SEP IRAs. The reason all IRA assets must be considered is because of the “pro-rata rule” for taking IRA distributions. Pre-tax 401(k) assets, on the other hand, are not considered in the pro-rate rule formula.
Before you rule yourself out based on that third condition about pre-tax IRA assets, you may still have options to explore.
You may choose to take an upfront tax hit and convert your pre-tax IRAs to a Roth IRA, thereby making them eligible for the back-door Roth contribution.
You may be able to roll your IRA balance into your 401(k) plan, to remove those assets from the pro-rata rule formula.
Whether or not these strategies make sense for you depends on your unique circumstances… which is where it can be handy to turn to a wealth manager to coordinate the necessary financial and tax planning analyses needed. For a more detailed analysis of your specific case, please contact us at 561-491-0231.
Core Wealth Management is a fee-only wealth management firm located in Jupiter, FL. Our CFP® professionals provide investment management, financial planning and advisory services, while always strictly abiding by the highest fiduciary standards. For more information, contact us today at 561-491-0231.
Jackie Goldstick, CFP® is the Director of Financial Planning at Core Wealth Management. She is a member of the National Association of Personal Financial Advisors (NAPFA) as well as the Financial Planning Association (FPA).