Lesser Known Tax Loophole to Maximize your Roth IRA
Did you know there are ways to take advantage of Roth IRAs even if you exceed the annual income threshold? As of 2020, an income of $139,000 (or $206,000 if filing jointly) makes an individual or married couple ineligible for Roth IRA contributions.[i] A legal tax-loophole exists that you may not have heard of using an IRA conversion strategy sometimes called a “back-door Roth”. In this article, we will review how to utilize this savings technique to help build up your retirement savings for tax-free withdrawals from Roth IRAs.
Traditional Vs. Roth IRA
In a traditional IRA, your contributions are tax-deductible for state and federal taxes in the year you make the contribution, but you pay tax on all withdrawals in retirement. In a Roth IRA, you receive no tax break for contributing in the current year, but your withdrawals in retirement are generally tax-free. Anyone can make an annual contribution to a traditional IRA, but determining if the contribution is tax-deductible will depend on your income and if you are covered by an employer-sponsored plan, like a 401(k). Traditional IRAs have withdrawal rules, so when you reach age 70 ½ you have to start taking required minimum distributions (RMDs) which are mandatory and taxable.[ii] There are also tax and potential penalties to withdrawing from a traditional IRA before the age of 59 ½. On the other hand, you can withdraw contributions (but not earnings) from a Roth without penalty. Roth IRAs do not have RMDs and so if you have enough income in other areas, you can let your Roth IRA grow tax-free throughout your lifetime, making a Roth IRA a good wealth-transfer vehicle for the next generation. Even better, beneficiaries of Roth’s do not owe income tax on withdrawals either.
IRA Conversion Strategy, aka “Backdoor Roth”
So, now that you know the difference between a Traditional and Roth IRA, how can you take advantage of the tax and withdrawal benefits of a Roth if you exceed the income limits? Everyone is entitled to contribute the maximum annual contribution amount on a non-deductible basis to a Traditional IRA. Once you make the non-deductible contribution, you can then convert the contribution (tax-free) into a Roth IRA avoiding the income limitations by using this tax loophole.
Before utilizing this strategy, be sure to educate yourself on the pro-rata rule for IRAs. This is the formula used to determine how much is taxable (if any at all) when you use the tax loophole strategy. The IRS looks at all of your SEP, SIMPLE, and Traditional IRAs as if they are one in the formula. If you have no IRA accounts at all, this strategy works best since no pro-rata rule applies. Utilizing a SoloK (vs a SEP) can also be a big advantage for those with small businesses, allowing one an avenue to avoid pro-rata rules by consolidating retirement assets under the SoloK. You also have the ability to convert pre-tax IRA assets into a Roth IRA but know you will pay income tax in the year of the conversion on the full amount converted to the Roth.
Is it Right for You?
Tax diversification in retirement is an underappreciated concept that we continue to keep an eye on. Tax-free assets lock in today’s low tax rates, limiting some downside should taxes increase in your retirement years. Historical tax rates would amaze the average investor and, we believe, motivate many to take advantage of tax-free investment accounts today. This article goes over some of the basics. You can decide if making a Roth Conversion and utilizing the tax loophole strategy makes sense. In general, we have met very few people that make nondeductible contributions to their IRA on their own. Do your research, talk to a qualified financial planner and your accountant, and review your tax diversification strategy to help make the best choice.
Commonwealth Financial Network® or Doble LeBranti Financial Group does not provide legal or tax advice. You should consult a legal or tax professional regarding your individual situation.
About the Author
I am an avid gardener, a trait I inherited from my Sicilian grandfather. Herb, cucumber, spinach, lettuce, and tomato varietals fill my yard each Summer. I am the only person in my neighborhood bold enough to plant vegetables in the front yard (best sun). Get me talking about growing tomatoes and the conversation might never end. The garden is a special place for my two daughters and me. We chase each other around the eggplants, search for cucumbers hiding under the vine, dig for worms, and pluck tomatoes just as they show a tint of ripeness.