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Proactive Tax Planning 3 of 6

One Roth IRA Workaround for High-Income Earners

If you understand the concept of compounding interest and believe your money will grow over time, then you’d be wise to supplement pre-tax retirement plans with a Roth IRA. After all, it’s the most recognized vehicle for tax –free growth and tax-free distribution. Yet, high-income earners can’t contribute to Roth IRAs. Per the IRS as of 2017, if you’re single and earn more than $118,000, or are married and file a return joint return with income over $186,000, the IRS starts to say “no can do” if you try to contribute to the Roth IRA.

But, all hope is not lost. If you can’t contribute to a Roth IRA based on income limits, there is still a way to get money into this tax-free vehicle, provided your situation is right and you follow some specific rules.

Here’s how it works.

  • Contribute to an IRA but do not deduct the contribution as a pre-tax contribution. The IRS calls that a “Non-Deductible IRA”
  • Wait a bit while your savings (hopefully) accumulates. We recommend one year or longer.
  • Then covert the tax titling of this savings to a Roth IRA for tax-free growth moving forward. Some people refer to this strategy as a “Back-door Roth IRA”

Easy, right? Not so fast. Before you go and contribute to a non-deductible IRA, understand a common situation where this strategy doesn’t work. The IRS has a pro-rata rule in place for converting pre-tax IRAs. This means that if you have traditional IRA monies already, and then decide to open a non-deductible IRA and try to convert those dollars later, the IRS views this as an action across all IRA accounts and will include your traditional IRA in the calculation of taxes.

Here’s the math on the taxable consequences of a conversion:

Example #1

  • You contributed $5,000 to Non-Deductible IRA one-year ago.
  • The balance of the account grew to $6,000 ($1,000 of investment growth)
  • No other deductible IRAs
  • Your goal is now to convert the full $6,000 Non-Deductible IRA balance to a Roth IRA for tax-free growth in the future
Non-Deductible Contribution Non-Deductible Growth Total IRA Balance Non-Taxable Portion Taxable Portion
$5,000 $1,000 $6,000 $5,000/$6,000 (83.33%) $1,000/$6,000 (16.67%)

If in the 25% tax bracket, you will owe the IRS $250 for this conversion ($1,000 x 25%).

Example #2

  • You contributed $5,000 to Non-Deductible IRA one-year ago.
  • The balance of the account grew to $6,000 ($1,000 of investment growth)
  • You also have $100,000 invested in a Traditional IRA, which was once an employer sponsored 401(k) plan many years ago
  • Your goal is now to convert the full $6,000 Non-Deductible IRA balance to a Roth IRA for tax-free growth in the future
Non-Deductible Contribution Non-Deductible Growth Total IRA Balance Non-Taxable Portion Taxable Portion
$5,000 $1,000 $106,000 $5,000/$106,000 (4.72%) $101,000/$106,000 (95.28%)

If you want to convert the full $6,000, then 95.28% of this balance is taxable ($5,717).

If in the 25% tax bracket, you will owe the IRS $1,429 for this conversion ($5,717 x 25%).

So if you don’t have any other IRAs (Example 1), this “Back-door Roth IRA” strategy may work for you. If you do have other IRA assets (Example 2), there is work-around for this strategy, granted it is probably much less common. If you have an employer-sponsored retirement at work, such as a 401(k), and it allows for non-payroll contributions, you might consider moving your Traditional IRA into the 401(k). Carefully review the plan rules, investment options and management fees, and consider the balance of the Traditional IRA. You’ll want to ensure you aren’t letting the tax tail wag the investment dog.

In summary, we aren’t saying this strategy is right or wrong. We do however want you to note the basic tax calculation before thinking that a non-deductible IRA is as good as a Roth contribution. The IRS is smarter than to allow it to be that simple.

Traditional IRA account owners should consider the tax ramifications, age and income restrictions in regards to executing a conversion from a Traditional IRA to a Roth IRA. The converted amount is generally subject to income taxation. This information is not intended to be a substitute for specific individualized tax advice.

We suggest that you discuss your specific tax issues with a qualified tax advisor. Haas Financial Group, US Financial Advisors and LPL Financial do not provide tax advice or services.

Securities offered through LPL Financial, Member FINRA and SIPC. Investment advice offered through U.S. Financial Advisors, a registered investment advisor. U.S. Financial Advisors and Haas Financial Group are separate entities from LPL Financial.

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