Is the backdoor Roth IRA all it’s cracked up to be?
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Since its inception, the Roth IRA has been one of the most coveted types of retirement accounts for a new generation of savers because of its unique potential to realize powerful retirement savings growth. With the costs of retirement escalating thanks to expensive health care, longer lifespans and the threat of inflation, investors are turning to Roth IRAs as a means to supercharge their retirement funds.With traditional IRAs, you receive a tax deduction on your contributions in any given year in exchange for taxable income once you retire. A Roth IRA reverses this; you fund your Roth with after-tax funds (money you’ve already paid taxes on) for the benefit of not having to pay taxes on your money when you retire and receive an income stream. Other powerful Roth features include the ability to access your contributions before 59 ½ and the lack of RMDs (required minimum distributions) associated with traditional IRAs. What these two do have in common, though, is the ability to currently contribute up to $5500 for those under 50 and up to $6500 for those over 50.
Savvy investors have fallen in love with the Roth because of its benefits. Unfortunately, many "wealthy" investors are simply phased-out from contributing to this type of retirement plan.In 2016 for instance, if you file married filing jointly and your income is above $194,000, or if you’re a single filer and your income is above $132,000, you are phased out of contributing to a Roth IRA. If you are an executive or a small business owner, it’s quite feasible that you could hit those limits quickly and be left without the Roth option.So what can you do to capture the power of a Roth?A strategy called a "backdoor Roth" gives investors who have a traditional IRA the option to convert it to a Roth even if they are above the Roth income limits. This strategy can let you capture the benefits of the Roth while sidestepping its income restrictions.
According to Daniel R. Zajac, CFP ®, AIF®, CLU, a partner at SimoneZajac Wealth Management Group, "A backdoor Roth can be accomplished by making a non-deductible contribution to a traditional IRA, and then immediately converting the traditional IRA to a Roth IRA. Since the contributions to the traditional IRA are post-tax contributions (you have already paid tax on this money), only the earnings will be taxable upon conversion."While this process is fairly simple, and can be quite beneficial in the long run, there are a few pitfalls that you need to be aware of before you use the backdoor approach."If you make your contribution to the nondeductible traditional IRA and then leave it there until it accumulates sufficient investment income to exceed the full contribution amount before you convert it, you will have to reverse the excess amount of the conversion before the end of the year or face a fine from the Internal Revenue Service. It is complicated for many people," says Cary Carbonaro, MBA, CFP®, author of The Money Queen.Also, many investors have multiple IRAs from either money rolled over from previous employer's 401(k) funds or outside IRAs set up as a means to stock up on savings. While this is a great strategy for socking away more retirement funds, having multiple IRAs can be a rat trap when considering the backdoor Roth approach.
As Zajac explains, "If you have more than one IRA and choose to backdoor a Roth, you must aggregate the total of your pre and post-tax IRAs for conversion purposes. The result of this rule may mean only a portion of your non-deductible IRA contribution is converted. Because of the potential complexity, meet with a tax planning expert to fully understand the impact prior to pulling the trigger."While the backdoor Roth IRA might be a good solution to retirement funding, it needs to be a well thought out strategy based on your individual financial situation. If done properly, the backdoor Roth could bring some valuable retirement savings relief to those individuals that love this vehicle, but can't fit the traditional guidelines.Photo credit: Ivan Malkin
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