Planning for retirement can be a bit tricky, especially for individuals just starting out. The most well-know IRA accounts are 'Traditional' or 'Roth' IRAs. Traditional IRAs allow you to defer paying taxes on money you save for retirement until you withdraw the funds from the account. Roth IRAs are designed so you pay the income tax now, and distributions that are made after age 59½ from accounts that are at least five years old are tax-free!!
Roth IRAs provide many advantages for lower- and middle-income retirement savers, and individuals that have a longer period of time to grow the income in the retirement account. The downside is that individuals with modified adjusted gross incomes (MAGI) above a certain amount are subject to a contribution phase-out, which eventually disallows direct contributions. In 2015, the schedule for married taxpayers filing jointly is $183,000-193,000; for Single and Head of Household filers, it's $116,000-131,000. Individuals with incomes above the top number in each category cannot contribute to a Roth.
However, for those that are lucky enough to exceed the threshold, don’t worry! The IRS removed the $100,000 MAGI limit for Roth conversions in 2010 creating a loophole in the tax code that allows you to legally funnel money into Roth accounts using a “back door IRA” strategy.
Here's how to use this "back door" strategy:
- Open a traditional IRA with your IRA custodian of choice. (It is usually easiest, but not necessary, to use the same custodian that holds your Roth conversion IRA – or where you plan to open your Roth.)
- Make a fully nondeductible contribution to your traditional IRA. The contribution limits in 2015 are $5,500 for those under age 50, plus an additional $1,000 catch-up contribution for those aged 50 and above.
- Next, you need to convert the traditional IRA balance into a Roth IRA. Because, as detailed above, the MAGI threshold for contributions does not apply to conversions, the income limitation is effectively thwarted.
Converting your traditional IRA balance to your Roth IRA needs to be done in a close amount of time because you will have to pay taxes on any income you accumulate between the date you contribute and the date you convert. If there is only a few days between the conversion, the gains are minimal.
Back-door IRA conversions are a great strategy to utilize depending on your investment goals. I would definitely encourage you to discuss this strategy with your tax advisor.