Is this retirement strategy right for you?
The door to Roth IRAs is closed to some high-income taxpayers because of annual limits imposed on contributions. But you may be able to use a “back-door” method that is perfectly legal. This technique may help you preserve more assets for your eventual retirement.
Background: With a Roth IRA, you can never deduct annual contributions, unlike with a traditional IRA. (Deductions for traditional IRAs are generally reduced or eliminated for taxpayers who participate in an employer-sponsored retirement plan.) Conversely, if a Roth has been in existence for at least five years, “qualified distributions” are completely tax-free. For this purpose, a qualified distribution is one
- made after you have reached age 59½;
- paid on account of death or disability; or
- used for first-time homebuyer expenses (up to a lifetime limit of $10,000).
In contrast, distributions from a traditional IRA are taxable at ordinary income rates, with a current top tax rate of 39.6%. Therefore, depending on your situation, you might prefer to contribute to a Roth IRA rather than a traditional IRA.
The contribution limit for both traditional and Roth IRAs for 2017 is $5,500; $6,500 if you are age 50 or older. (You may combine contributions to both types up to these limits.) However, the ability to contribute to a Roth is phased out for certain high-income individuals. For 2017, the phaseout occurs between $186,000 and $196,000 of modified adjusted gross income (MAGI) for joint filers; $118,000 and $133,000 MAGI for single filers. If you exceed the higher point of the phaseout range, no contributions are allowed for 2017.
To avoid the phaseout rule for contributions, you may decide to set up a nondeductible IRA. In other words, you contribute to a traditional IRA, even though you do not qualify for deductions or you choose not to claim them. With a nondeductible IRA, only the earnings are subject to tax. Then you can convert the traditional IRA to a Roth, thereby entering the Roth through the back door.
For example, say you have contributed $10,000 to a traditional IRA and have $2,000 of earnings. This is the only IRA you have, and you have not claimed any deductions. If you convert the nondeductible IRA to a Roth this year, you are taxed only on the $2,000 of earnings. After five years, any distributions are 100% tax-free.
There is, however, still another obstacle in your way. You cannot designate distributions as coming from a particular IRA. Any distribution from a traditional IRA is treated as coming out on a pro rata basis from all the IRAs you have. This could trigger a bigger conversion tax than expected, especially if you recently rolled over a distribution from a 401(k) or other company plan to a traditional IRA. To reduce the tax conversion impact, you might keep more funds in your plan account before using the back-door approach.
Does this retirement-saving strategy make sense for you? There is no “right” or “wrong” answer. It depends on your personal situation. Consult your professional advisers for guidance.