We meet with our clients regularly to discuss the issues that impact their financial life and invariably the Roth IRA is one of those topics that always comes up. For those of your that don’t know the basics of the Roth IRA, let me cover it. You contribute to a Roth account with after-tax money (meaning no tax savings today), but the account is never taxed again. That means you don’t pay taxes on any of the gains, dividends and interest in the account as the money grows nor when you take it out. Roth account monies, in general, can’t be accessed before age 59 ½ but despite that it’s still is a phenomenal financial life planning tool.
Roth IRAs have many advantages when it comes to saving, investing, tax-minimization, estate planning and asset protection. Most people are familiar with the basic Roth IRA contribution but we are going to share with you 7 different strategies to get your money in to a Roth account.
Strategy 1: Contribute Directly into a Roth IRA
For 2015, you can contribute the maximum $5,500 to a Roth IRA ($6,500 if you are age 50 or older by the end of the year) if you are single or the single head of a household and your modified adjusted gross income (MAGI as the IRS) is less than $116,000.
If you are married filing jointly, you can contribute the maximum amount to a Roth IRA if your income is less than $183,000.
You may make a partial contribution to a Roth IRA if you are single and your income is between $116,000 and $130,000 or if you are married filing jointly and your income is between $183,000 and $193,000. For those of your that are high income earners, you can’t contribute directly to a Roth IRA if your income is above those levels.
It’s important to note that your can also contribute to a Roth IRA for your non-working spouse. This allows you to contribute an additional $5,500 ($6,500 over age 50) to you retirement accounts.
If your income is low, the Roth IRA is a great place to be saving.
Strategy #2: Make a Backdoor Roth IRA Contribution
This is a technique for contributing to a Roth IRA when your income exceeds the contribution limits above. There is no income limit on contributing to a non-deductible Traditional IRA, nor on converting a Traditional IRA to a Roth IRA.
If you have a balance in any other IRAs (SEP, Simple, Traditional), the taxable portion of any conversion you make is prorated over all your IRAs; you cannot convert just the non-deductible amount.
In order to benefit from the backdoor, you must either convert your other pre-tax IRAs as well (which may not be a good idea, as you are usually in a high tax bracket if you need to use the backdoor), or else transfer your deductible IRA contributions to an employer retirement plan such as a 401(k) (which may cost you if the 401(k) has poor investment options).
To make a backdoor contribution, first make a regular contribution to a Traditional IRA with your IRA custodian. You do not specify to the custodian whether the IRA is deductible or not; it is just treated as an IRA. As soon as the contribution posts, convert to a Roth IRA.
While this sounds pretty simple, there are number of considerations that can mess up this strategy, including rollovers from outside accounts, not accounting for all of your IRA balances, not completing the appropriate tax forms amongst others. So make sure your know what you are doing or work with a qualified financial and tax professional before initiating your Backdoor Roth IRA.
Strategy 3: The Mega Backdoor Roth IRA
Be forewarned, this a strategy that can only work for a select percentage of the population. Essentially, the Mega Backdoor Roth IRA allows you to contribute up to an additional $35,000 each year into your Roth IRA ($70,000 for a married couple).
To take advantage of this strategy you need to have the right income and the right retirement plan. Basically, this only becomes applicable once your have maxed out your initial retirement plan contribution (e.g. your salary deferral). In 2015, that is $18,000 into a 401(k) / 403(b) ($24,000 if you are over age 50). Furthermore, if you could you should have maxed out your other IRAs already if eligible.
The premise behind this strategy is that you can make additional after-tax contributions to your retirement plan above the standard limits. There is no tax-deduction for the contributions, however, you can roll these contributions over to a Roth IRA which makes what was once taxable money, tax-free forever.
Your 401(k) plan must have the following features to do this:
There are other nuances of this strategy for an employee who doesn’t have the cash flow to support the $35,000 contribution or business owner that can possibly save money on the profit-sharing plan component of his / her retirement plan which we will discuss in future blog posts.
Strategy #4: Contribute to a Roth 401(k) at Work
If you are an employee and your company has a 401(k) or 403(b) plan, find out if your plan allows you to designate your plan contributions (e.g. Salary Deferrals) to the plan as Roth contributions. For those under the age of 50, you can contribute a maximum of $18,000 out of your paycheck in 2015 to the Roth portion of the account. If you are over 50 years of age, you can contribute $24,000 this year.
What’s great about the Roth 401(k)/403(b) is that there are no income restrictions on who can contribute, unlike the Roth IRA. You could make $10 million in wages and still contribute to the Roth 401(k). By contributing to the Roth portion of your 401(k) you will pay thousands of dollars more in taxes this year — over $6,500 if you’re in a combined federal and state income tax bracket of 35%.
At the age of 70.5 your will be required to take distributions form the Roth 401(k) but you won’t have to pay taxes on the Roth 401(k) withdrawals. You can avoid these required minimum distributions by rolling over your Roth 401(k) to a Roth IRA when you retire. This way the Roth IRA can continue to grow and you won’t have to take distributions if you don’t want to.
Strategy #5: Contribute to a Roth 401(k) in your Own Individual 401(k)
If you have your own business, are a freelancer or an independent contractor, you can set up your own Individual 401(k) plan. The rules are very similar to strategy #4 except that you can contribute more than $18,000 ($24,000 over the age of 50). The basics of this strategy is to ensure you open your Individual 401(k) plan with a custodian that allows for Roth 401(k) contributions.
The maximum contribution your can make for 2015 is $53,000 ($59,000 over the age of 50), but it’s only the salary deferral contribution of $18,000 ($24,000) that can be designated a a Roth contribution. The amount of money you can actually contribute is dependent on your income and whether or not your have formed your own corporation or are a sole proprietor.
Strategy #6: Convert your Traditional IRA into a Roth IRA
This strategy allows you to convert your pre-tax Traditional IRA contributions to a Roth IRA. In 2010, tax laws changed which allowed for Roth IRA conversions without any income restrictions.
When you convert your Traditional IRA to a Roth, the amount that you convert becomes taxable as ordinary income in the year of the conversion. This means that if you convert $10,000 in Traditional IRA money, you will report an additional $10,000 of income on your tax return. Please note that you don’t have to convert all of your Traditional IRA balance at one time. You can choose how much you want to convert to manage the tax implications of the conversion. An ideal time to make a conversion is in a low income year when your marginal tax rates are low (assuming your have the cash to pay the taxes on the conversion from outside of the Roth).
Strategy#7: Convert your Pre-Tax 401(k) to a Roth 401(k)
This is a relatively new strategy that is now available since the IRS started allowing “in plan Roth conversions.” This means that even if you are currently employed you can convert pre-tax money from your Traditional 401(k) to your Roth 401(k) within the same plan. This is all dependent upon whether or not your plan allows for Roth 401(k) contribution.
Let’s say you are an employee and made prior contributions to only your Traditional 401(k) account on a pre-tax basis. If your no longer wish to have Traditional IRA contributions or have a low-income employment year, your can change those previous contributions to the Roth portion of your 401(k).
It’s important to note that your will owe tax on the conversion because you are converting pre-tax money to a Roth. The tax must be paid from money outside of your 401(k) account and cannot come from withholding taxes on the conversion.
Also, when you leave an employer you have the option of rolling over your pre-tax Traditional 401(k) into a Roth IRA and owing taxes in that process similar to converting a Traditional IRA to a Roth IRA.
So there your have it, 7 different strategies to get your money into a Roth IRA. Considering all of the nuances involved in these strategies, it would be best for you to talk to a financial professional to look at your entire financial life in unison including your investment portfolio to maximize the impact of your decisions.