Yahoo Finance The Backdoor Way for High Earners to Get Into a Roth
Earning a bigger salary may give you more to invest, but it has an unintended consequence. A high income could bar you from contributing to a Roth individual retirement account, which offers tax advantages that especially may appeal to higher-earning investors.
Converting traditional IRA assets to a Roth gets high earners in through the back door. "The main benefit to the backdoor Roth IRA is the ability for younger, high-income earners to put away more money into a tax-free account for retirement and have it grow over their lifetime," says Ryan Wibberley, CEO of CIC Wealth in Gaithersburg, Maryland. Additionally, a Roth IRA doesn't require taking minimum distributions beginning at age 70.5 the way a traditional IRA does.
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Many people enter retirement without the ability to control their tax destiny, Wibberley says. Often, they have the lion's share of their retirement assets in a taxable 401(k) or traditional IRA. A Roth IRA, though, lets you access tax-free dollars in retirement, offering greater flexibility when you have other sources of income that are taxable. Putting a backdoor IRA to work for you could potentially yield substantial tax savings in retirement.
Play by the aggregation rule. Although your goal is to minimize tax liability, a backdoor IRA could inadvertently trigger a larger tax bill because how the conversion is taxed hinges on the tax status of your traditional IRA assets.
If your traditional IRA is non-deductible because your income was too high for you to deduct contributions, a Roth IRA conversion is nontaxable. Contributing to a non-deductible IRA when you also have pre-tax traditional IRA assets, on the other hand, could throw a wrench in your plans because of the aggregation rule. It requires that the total value of all traditional IRA accounts, both deductible and non-deductible, be added together when determining the tax consequences of taking a distribution. The rule does not apply to inherited IRAs.
As a result, "an existing traditional IRA would have to be converted in its entirety," says John Knolle, principal at Saranap Wealth Advisors in Walnut Creek, California. "For existing IRAs with large pre-tax balances, converting could mean a hefty tax bill because after-tax contributions are converted pro-rata to the overall balance."
For example, if you have a $10,000 traditional IRA consisting of $2,000 in after-tax contributions and $8,000 in pre-tax conversions, you wouldn't be able to convert the after-tax portion alone. Every after-tax dollar converted would also have $4 of pre-tax dollars accompanying it, Knolle says. "This is known as the 'cream in the coffee' rule, meaning once after-tax dollars are mixed with pre-tax dollars, it's impossible to separate the two."
If the resulting tax bill will be exceptionally high, converting an IRA for the sake of making a backdoor contribution may not be worthwhile, especially if you're closer to retirement and won't be making any subsequent backdoor contributions.
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Depending on your current tax bracket, you may be better off maxing out your before-tax investment options before taking the backdoor route. "If you expect your tax bracket to be much lower in the future, it might not make sense to pay taxes now in a higher bracket just to eliminate taxes in the future," says Gretchen Cliburn, director at BKD Wealth Advisors in Springfield, Missouri.
The rule has an exception that could potentially minimize taxes, says Mary Evans, senior client advisor with TFC Financial Management in Boston. Employer plans, such as a 401(k), aren't counted in the aggregate rule. This creates a potential work-around if your employer's plan accepts pre-tax rollovers.
"If the pre-tax dollars in existing IRA accounts are rolled into your 401(k), that would leave only after-tax IRA funds, setting the stage for a backdoor Roth IRA," Evans says. If you have a workplace retirement plan, ask if IRA rollovers are accepted.
Mind the step transaction doctrine. The timing of the conversion matters. Ideally, Wibberley says, the conversion should be done when the account values are at their lowest point during the calendar year. That could help mute any tax impact.
Keep in mind you may be able to correct a poorly timed conversion. "If you time the conversion imperfectly, you still have the option to reverse or recharacterize it, then immediately redo the conversion at the lower current values," Wibberley says. For some investors, it may make sense to split a conversion up over two calendar years to minimize the amount of taxes due, he says.
You'll also need to decide how much time to allot between the initial non-deductible IRA contributions and a conversion because there's no hard and fast rule to follow. "The law is silent on how long one must wait between making the IRA contribution and converting it to a Roth IRA," says Chip Olson, senior vice president and senior wealth advisor at People's United Wealth Management in Bridgeport, Connecticut. Some experts suggest waiting 30 days, while others advise delaying up to six months or a year. Although the timing is up to you, beware of the step transaction doctrine.
This doctrine says that the U.S. Tax Court can examine separate steps in a transaction and treat them as a single tax event. In the case of a backdoor Roth IRA, completing the steps in rapid sequence could be read as an intent to make a Roth IRA contribution that wouldn't ordinarily be allowed because of your income. In that case, the IRS could disallow the conversion, resulting in a tax penalty.
Report it correctly on your tax return. A backdoor IRA conversion in itself is relatively easy, but reporting it can trip investors up, says Michael Hohf, financial advisor and certified financial planner at Advance Capital Management in Southfield, Michigan. "The most complicated step is reporting the non-deductible contribution and subsequent conversion correctly on your tax return," Hohf says. "Tax software systems often don't do a good job of accounting for this strategy, or taxpayers don't input the information correctly."
[Read: Use Your Tax Return to Cut Next Year's Tax Payment.]
If you use the backdoor IRA strategy, make sure you get it right on your taxes the first time. "That way, you'll avoid a letter from the IRS asking for clarity, which adds anxiety, time and cost to the process," Hohf says.
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