Every once in a while, Congress opens a window that smart investors need to jump through. The new tax law makes a Roth IRA available to a wide swath of Americans and the reasons to convert are compelling.
This “backdoor” approach allows folks who earn too much to contribute directly to a Roth IRA to fund one anyway. Yes, it sounds crazy, but have you watched the news from Washington DC lately?
It works like this: If you earn more than $120,000 as a single, or $186,000 as a couple, and you contribute to a traditional, nondeductible IRA, instead of a Roth. Then, “presto chango,” you immediately convert the deposit into the traditional IRA to a Roth IRA. In a conference committee report, Congressional tax writers have blessed this technique and taken it out of the gray area. Previously, some tax experts expressed concern that the Internal Revenue Service might argue that the two-step process violates what’s known as the step-transaction doctrine.
“When Congress says what its intent is, that’s it. They absolutely, clearly say it’s okay. You can make a contribution to a nondeductible IRA and convert it to a Roth,” according to CPA and IRA expert Ed Slott, publisher of the IRA Advisor Newsletter.
Here’s how the concept works for Roth IRAs: you can deposit $5,500 a year into one of these accounts–$6,500 if you’re 50 or older. While you get no tax deduction for your contribution, the money in a Roth grows tax-free for retirement. Should you need cash earlier, you can withdraw your original contributions at any time without taxes or penalties. After 59 ½ you can access all of it, including earnings, tax-free.
But wait, there’s more! You don’t have to withdraw money each year beginning around age 70 ½ like you do with a traditional IRA. Utilizing a Roth IRA gives you more control of your taxable income in retirement. Further, if you leave a Roth IRA to individual heirs, by naming them on your beneficiary form, they can continue to enjoy tax-free growth over most of their lifetime.
There are some gotchas with the backdoor Roth. First, you need wages or self-employment income to get to the first step—making the traditional IRA contribution. Second, you can only do this up until the year before you turn 70 ½. Third, if you want to take contributions out before age 59 ½, there’s a special rule that says you have to wait five years for each conversion.
The fourth gotcha is the biggest but only applies if you have other traditional pre-tax IRAs. If you have money sitting in these accounts, it gets counted pro rata, and you’ll face an income tax hit on the conversion. One way around this is if you participate in a 401(k) that lets you roll money in from an IRA. That leaves you with only the new traditional IRA you fund each year, and you can convert it immediately with no tax hit, according to Mr. Slott.
It is worthwhile to note the new tax law eliminates the ability to “re-characterize” or reverse Roth conversions for taxpayers with large traditional IRA’s and does not apply to those doing serial, annual backdoor conversions.
The bottom line is this: if you can take advantage of this technique you should give the backdoor Roth Conversion close consideration. It’s smart to review this strategy with your CPA but smart investors will take advantage of this until Congress changes its mind at some point in the future.