Retirement accounts come in different “flavors”, each with its own special features, benefits, and regulations. Taking advantage of available retirement savings vehicles is one important objective when we’re offering guidance to WEFA clients.
From its inception 18 years ago, it was apparent the Roth IRA was a different breed. Unlike contributions to traditional IRAs, 401(k)s, or 403(b) retirement plans, contributions to a Roth IRA are not tax-deductible. As is true with other retirement plans, the money in a Roth IRA grows tax free (with transactions including capital gains, dividends, and interest incurring no tax liability when earned).
The big difference between Roth IRAs and all the other retirement plans becomes evident upon withdrawal, because not only may principal contributions (known as “basis”) to a Roth IRA be withdrawn tax and penalty-free at any time, once the 5-year rule and the condition of age 59 ½ are met, all distributions out of a Roth IRA are tax-free!
High-income individuals were barred from taking advantage of all these options. Not only were they not allowed to contribute to Roth IRAs, their contributions to “regular” IRAs were not deductible upfront. Funds in traditional IRAs could be “converted” into Roths if the tax was paid, but, until 2010, those who earned above $100,000 were shut out of that strategy as well. In 2010, the $100,000 limit was removed, but for those in the highest tax brackets, converting from traditional to Roth IRA came at too high, of a tax cost.
Where there’s a will, there’s a way, as the old saying goes, and a new two-step strategy came onto the scene nicknamed “the Backdoor Roth IRA”. There’s a debate going on in Congress about this strategy, with some lawmakers viewing it as an abuse of the retirement vehicle. It’s possible the window (or door?) of opportunity will close in 2016. If that happens, it’s likely that 2015 backdoor transfers would be “grandfathered”; advisers are urging clients to“backdoor” their IRAs before the law changes.
For high-income individuals not otherwise eligible to contribute to a Roth IRA, “backdooring” is done in two steps:
Keep in mind, this strategy works best when the nondeductible IRA is the taxpayer’s only IRA account. If there are other IRA accounts with deductible contributions in them, the conversion is treated as having come pro rata from all IRA-type accounts. That can negate the attractiveness of the Backdoor Roth IRA.
“Don’t try this at home” is the mandatory disclaimer heard during any TV show which presents stunts and death-defying acts. When discussing complex tax strategies such as the Backdoor Roth IRA, we at WEFA agree: don’t try this without consulting your financial planner or tax advisor!
Content was prepared by a freelance journalist on behalf of Worley Erhart-Graves Financial Advisors