by Steven T. Merkel
Without hesitation, most financial professionals will unarguably agree that the Roth IRA is hands down the best individual retirement arrangement on the planet. Benefits such as tax-free growth, no RMD requirements at age 70 ½, and penalty-free early withdrawal of principal are just a few of the many benefits. But to date… it is the only IRA retirement plan that offers 100% tax-free withdrawals of principal and earnings after age 59 ½, provided that the Roth was established for at least five years before the distribution occurs. Why wouldn’t everyone have one?
LIMITATIONS AND RESTRICTIONS
Eligibility to contribute directly to a Roth IRA is phased out at certain modified adjusted gross income (MAGI) levels. Roth contribution eligibility (indexed for 2015) ends at MAGI limits for single tax filers at $131,000 and $193,000 for those married filing jointly. If you have earned income under these MAGI levels, you can contribute directly to a Roth for both you and your spouse – at a maximum of $5,500 each per year or $6,500 if you’re age 50 or older.
In 2010, the government removed the $100,000 income limitation for Roth conversions. Roth conversions allow taxpayers to convert full or partial Traditional IRA funds (both deductible and non-deductible) to Roth IRAs by paying tax on the untaxed amount converted in the year of conversion. The removal of this rule also opened up some amazing strategic planning opportunities for both low and high income earners.
If your earned income MAGI exceeds the direct contribution limits to the Roth IRA, there’s still a possible solution for you. The IRA rules allow those individuals that can no longer benefit from deductible IRA contributions to make non-deductible contributions to a Traditional IRA (make sure your CPA files Form 8606 with your tax return to acknowledge the non-deductible contribution). Immediately after your contribution posts to your non-deductible IRA, you should convert the funds to your Roth IRA account. Presto… you now have a Roth IRA and you converted it without paying any tax! How? There were
no earnings in the non-deductible Traditional IRA at the time of conversion and you never took any tax deduction for the contribution, so there was nothing new there for the IRS to tax since your initial contribution was comprised of after-tax dollars.
WATCH OUT FOR THE PRO-RATA RULE
The catch to this strategy is if you already have existing IRA accounts. In this case, the IRS would look at the aggregate value of all of your Traditional IRA accounts and tax the amount of your conversion based as a percentage of the overall value of all of your IRA accounts.
This is not the best scenario because you would still owe some tax on the conversion amount based on the pro-rata formula. If conversion still interests you, keep in mind that you do not have to convert the entire IRA to a Roth in the same tax year, so many individuals are still able to spread the tax consequence over several years by only converting a partial amount of their deductible (taxable) IRAs each year.
AVOIDING THE PRO-RATA RULE
Should you desire to reduce your pre-tax IRA values to zero in order to avoid paying tax on the conversion amount, you could consider rolling over your IRA accounts into a 401K plan prior to opening a non-deductible IRA. Since many employers do not allow outside pre-tax IRA monies to rollover into their plan, if you have self-employment or 1099 income, consider opening a Uni or Solo 401K to rollover the funds. If you get your aggregate IRA values down to zero, you can then utilize the Backdoor
Roth with no tax due.
The Backdoor Roth is an excellent strategy if you do not have any existing pre-tax Traditional IRA accounts or you’re able to rollover those funds into a 401K account. The ability to convert non-deductible IRA funds to a Roth IRA tax-free is an amazing tax and investment strategy that can provide family generations of tax-free earnings and distributions. There’s no other product out there like it. Even retirees with no earned income may want to consider partial Roth conversions (paying tax now on the conversion amount of course). So what are you waiting for? Contact your financial planner today to fully understand your personal tax situation and then get the ball rolling on this incredible opportunity before the IRS fully catches on and makes changes to the tax code.
Steven T. Merkel
Steven T. Merkel CFP®, ChFC®
Ciccarelli Advisory Services, Inc. is located at 9601 Tamiami Trail North, Naples, FL (239.262.6577)
Investment advisory services offered through Ciccarelli Advisory
Services, Inc., a registered investment adviser independent of FSC Securities
Corporation. Securities and additional investment advisory services offered
through FSC Securities Corporation, member FINRA/SIPC and a registered
A Roth IRA distribution is qualified if you’ve had the account for at least
five years and/or the distribution is made after you’ve reached age 59½, due
to total and permanent disability, in the event of your death or for first-time
homebuyer expenses. Distributions made prior to age 59 1/2 may be subject
to a federal income tax penalty. If converting a traditional IRA to a Roth IRA,
you will owe ordinary income taxes on any previously deducted traditional
IRA contributions and on all earnings. A conversion may place you in a higher
tax bracket than you are in now. Since Roth IRA conversions may not be
appropriate for all investors and individual situations vary we suggest that you
discuss tax issues with a qualified tax advisor. There are several choices investors
have when rolling over money from one plan to another. Since each choice
has its own implications, it is recommended that you discuss and compare all
potential fees, expenses, commissions, taxes, and legal ramifications with your
qualified advisor before making a rollover decision.