By Kim R., Branch Stock Broker and Guest Blogger
Many find the Roth IRA an attractive way to save for retirement. And who can blame them? The money you put into a Roth IRA grows tax-free and you’re not required to take withdrawals at a certain age. Sounds great, but the trouble for some is that they don’t qualify to make contributions to a Roth IRA.
That is true for my aunt and uncle. They’re ineligible for a Roth because their modified adjusted gross income (MAGI) is above $188,000. What my aunt and uncle didn’t realize until recently is that they can contribute to a Roth through a “back door.”
How the Backdoor Roth IRA Works
In 2010, the opportunity to convert a traditional IRA or other qualified plan to a Roth IRA was opened to all taxpayers regardless of income – the backdoor Roth IRA was born. Individuals whose income prevented them from contributing to a Roth IRA could finally skirt around the restriction by making non-deductible contributions to a traditional IRA and then immediately converting it to a Roth IRA.
What to Consider Before Converting Non-Deductible Contributions to a Roth IRA
Converting funds to a Roth IRA is an important decision to think through because most of the time it is a taxable event. You will have to pay income taxes on any gains in your non-deductible IRA. If your non-deductible IRA has no gains or had a loss, your conversion would not be taxed.
Now the catch: Let’s say you have made deductible contributions or rolled over a qualified plan like a 401(k) to a traditional IRA and then you make a non-deductible contribution to the traditional IRA. In that instance a portion of the amount you convert is taxable at ordinary income tax rates. To determine what is taxable you divide the non-deductible contributions, also known as your basis, by the total aggregate value of all your traditional IRAs. For example, if the value of your traditional IRA is $100,000 and you have made $5,000 in non-deductible contributions you will need to pay tax on 95 percent of the conversion. So if you decide to convert $5,000 you will be responsible for the tax on $4,750.
In theory a backdoor Roth IRA has its advantages. But it is important to consider your current income tax rate, your expected future income tax rate, and the anticipated return on your investments in a Roth IRA vs. a traditional IRA. You don’t want the conversion to be a tax burden. It’s a good idea to talk with your tax advisor when exploring IRA conversions and whether or not a backdoor Roth IRA is right for you. More than likely your situation might be more complex than the examples provided above.
What have been some of the advantages you have found with IRA conversions?
Also of Interest:
Kim R. started at Scottrade in 2011 and is a stock broker at the Providence, R.I.
This material is for informational purposes only and should not be construed as a recommendation or investment advice.