Roth IRAs for High Income Earners

By Jason Watson (Google+)

When it comes to saving for retirement, making too much money means that Uncle Sam shuts the door on many of your tax breaks. Specifically, for those who want to invest in Roth IRAs, once the income limits have been reached eligibility for contributions are reduced or eliminated. Unlike Traditional IRAs that defer taxes until withdrawals are made, Roth IRAs are funded with paid up front contributions. Many opt for a Roth IRA because knowing your tax rate now, is easier than speculating what your income and tax rate will be 20 to 30 years from now.

As of 2013, the income limits for Roth IRAs based on filing status are:

Married filing Jointly or Qualifying Widower
$188,000 ($178,000 phase out begins)

Single or Head of Household
$127,000 ($112,000 phase out begins)

But guess what? A few years ago lawmakers created a loophole. Imagine that! A politician creating a loophole that everyone can use. Back in 2010, the tax laws for income limits on IRA conversions expired. Uncle Sam forgot to close the backdoor when they opened it back up. That means taxpayers who make too much can make contributions to a non-deductible IRA then convert it to a Roth IRA.

This approach first begins by opening up a non-deductible Traditional IRA with a contribution up to the current dollar limits. For 2013, those under 50 years can contribute up to $5,500, and those over 50 can contribute up to $6,500. Exceed that amount and you get to pay a nice excise tax of 6%. Your contributions are your “cost basis” in the plan. Make sure to report all non-deductible contributions on Form 8606 each year. Failure to do so, will cause the entire amount of your distributions to be taxed. In other words, your non-deductible contributions could be double taxed.

Next, make an immediate conversion to a Roth IRA. If the conversion is done right away, there shouldn’t be any taxes owed. The amount contributed was already taxed and with an immediate conversion, there aren’t any earnings. If you wait too long, any earnings from the contributions will be taxed.

The good news is if you already have an existing Roth IRA, you don’t have to open a new one. So if you opened one up prior to reaching the income limits just rollover to that account. Otherwise, a new Roth IRA account will have to be opened and rollovers can be made to that account in subsequent years.

This backdoor comes with a catch of course. According to the IRS, rollovers are a taxable event so in a conversion, the IRS considers the combined balance of all Traditional IRA accounts. This is known as the pro-rata rule. If you have balances in other existing Traditional IRA accounts that include deductible contributions and non-deductible contributions, the rollover will be taxed based on the prorated amount of non-deductible contributions to the total all of your accounts combined. Huh?!

Let’s say you have several Traditional IRA accounts with a total combined balance of $150,000. If $30,000 represents the total of non-deductible contributions, the prorated amount is 20%. In other words, 20% of the rollover is tax free. The remaining amount will be taxed at your current income tax rate.

Just in case you were wondering, you cannot split the deductible and non-deductible amounts. Attempting to roll over just the tax free non-deductible contributions will not work in your favor. The pro-rata rule applies to any amounts rolled over. Meaning, if you only roll over $10,000, only 20% of the rollover is tax free. You would pay taxes on $8,000 and the remaining $2,000 would be tax free. No bueno! Mostly likely that was not your original intention. So, you either roll over all accounts in the Roth IRA, or none at all.

Self-employed taxpayers or owners of S-Corps can do the same thing with a SEP, and a SEP has a $55,000 (as of 2013) contribution limit. So, not only does the Roth IRA have income limits it also has contribution limits. Self-employed people can max out a SEP and convert it to a Roth IRA and bypass both income and contribution limits. Wow!

The benefit or payback period on the tax paid today depends on your current tax bracket. Lower brackets such as 15% can see payback periods of 3-5 years and 28% might have to wait 7-9 years. After the “payback” period, the tax benefit is now in your favor.

As you can see , this approach unfortunately may not benefit everyone. For those high earners who are first time Roth IRA investors, this workaround is suited for them. For those who already have several Traditional IRA accounts opened, the balances in the accounts and years left until retirement, will determine if a conversion makes sense.

Also, we’ve seen some financial advisors make extremely bad decisions when it comes to advice given on conversions. A client of ours wanted to convert about $400,000 from a Traditional IRA to a Roth. Easy cheesy. But his financial advisor converted ALL of it in one year. So, our client suddenly jumped into the highest tax bracket with conversion- he saved at a marginal rate of 15% all his years and paid taxes at 36%. Had he spread the conversion out over a handful of years, we would have saved thousands of dollars in taxes. We were able to reclassify the conversion by October 15 and save this mess.

One more thing- check out the conversion calculator from Charles Schwab. They do an excellent job of giving you the payback period.