Back Door Roth IRA Strategy for High Earners

Not only is today the tax filing deadline, it’s also the deadline for making 2016 IRA contributions. Roth IRAs, which are funded with after tax dollars, have some significant benefits such as tax-deferred earnings, tax free withdrawals in retirement, and not being subject to required minimum distributions. Perhaps most enticing is that Roth IRAs can be passed down to your heirs outside of probate and the beneficiaries receive the funds tax free, just like you would in retirement.

Many higher earners, however, believe that they are unable to contribute to a Roth IRA because of the income limits set by the IRS. Specifically, current IRS regulations stipulate that single filers with income of $133,000 or more and married filers making more than 196,000 cannot directly fund a Roth IRA.

Enter the “back door” Roth IRA strategy.

Here is how it works:

Step 1 – Open and fund an after-tax traditional IRA (non-deductible) for each filer. Anyone is eligible to do so, even if contributing the maximum to a company 401(k) plan. Be sure to stay under contribution limits which are $5,500 per person in 2016, or $6,500 if over age 50. For example, a married couple with both spouses over the age of 50 can contribute a combined amount of $13,000 for 2016.

Step 2 – After the after-tax traditional IRA has been setup it can be converted to a Roth IRA. Your IRA administrator and/or tax advisor can provide instructions and assist you in accomplishing the conversion. If you already have an existing Roth IRA, the converted balance will likely go right into the existing account. If not, then you’ll need to open one during the conversion process.

Step 3- Pay your taxes upon conversion. Roth IRAs can only receive post-tax dollars. Therefore, if you deducted your traditional IRA contributions and then decide to convert them, you’ll have to refund that deduction. In addition, you’ll need to pay taxes on any investment gains that occur in the traditional IRA account prior to conversion.

As always, there are some caveats to this strategy, so we recommend consulting a tax advisor prior to putting the strategy to work, especially if you have existing IRAs. However, if you are able to take advantage of this strategy, your after-tax contributions will grow tax free and not be subject to taxes upon withdrawal by you or your heirs. After all, who doesn’t like tax free!

Please do not hesitate to contact us if you would like to discuss this strategy, your financial plan, or your estate plan. We would be happy to assist you!

– Daniel Ippolito