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to a Traditional IRA can be withdrawn without taxation, but earnings are taxed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IRA are tax-free and contributions can be withdrawn at any age without tax or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.
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.
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