Are you already maxing out your employer 401(k) or 403(b) and wondering what else can you be doing to save for retirement? One vehicle that is available to save for retirement is the Roth IRA.
Contributions are made after-tax, investments grow tax free, and withdrawals in retirement are 100% tax-free. The maximum contribution limit for 2018 is $5,500 plus an additional $1,000 if you are age 50 or older. Sounds like a no brainer to implement this into your savings strategy. However, the one kicker is that there are restrictions based on income for whether you are even able to contribute to a Roth.
Ability to contribute to a Roth IRA begins to phase out at income levels of $120,000 for single & $189,000 for married filing jointly. If your modified adjusted gross income is at $135,000 single or $199,000 married filing jointly, then no contributions can be made directly to a Roth. Seems unfair, right?
If you fall into the income level that restricts you from contributing, there might be a way for you to funnel savings into a Roth another way. This strategy is often referred to as the Backdoor Roth IRA Strategy. Essentially, non-deductible contributions are made to a traditional IRA and then converted to a Roth IRA. Unlike the most common way of contributing to an IRA and receiving a tax-deduction, this contribution has no immediate tax benefit. The Traditional IRA serves as a conduit to funnel additional savings into the Roth that grows tax free and can be withdrawn tax free in retirement.
To take advantage of this, one must open a Traditional IRA & a Roth IRA. For example, John Doe makes a $5,500 non-deductible contribution to his Traditional IRA. Once the $5,500 settles into his IRA, a distribution is made coded as a Roth Conversion which transfers the funds into his Roth IRA. This enables $5,500 to be invested, grow tax free, and be withdrawn 100% tax free in retirement.
The one caveat to this is if you already have existing IRA’s that contain pre-tax dollars. All owned IRA’s, including SEP and SIMPLE IRA’s, are included in a pro-rata calculation which means some of the conversion may be taxable. The IRS does not let you pick and choose which IRA dollars you’d like to convert when you have IRA’s that contain pre-tax & after-tax dollars. But, if you do not have any existing IRA’s, then you for sure can take advantage of this strategy and ensure that your contribution will be converted tax-free.
If you would like more information on the Backdoor Roth IRA Strategy, please feel free to reach out.