What to Look For
The advantage of a Roth IRA over a Traditional IRA is that it allows you to withdraw all of the funds tax-free. However, if your joint tax return shows that you have earned $193,000 or more, you are not eligible to contribute to a Roth IRA. Yet, there are still possibilities to take advantage of Roth IRA benefits, if you do so strategically.
While those individuals in this higher income bracket cannot contribute to a Roth IRA through traditional means, there is a backdoor method for converting to a Roth IRA. Here’s how it works: Make a contribution to a nondeductible IRA, which has no income limits. You wouldn’t want to keep your income in the nontraditional IRA because the accumulated income is taxed at ordinary income rates when withdrawn. So, shortly after the contribution is made (there is no time requirement) convert the non-deductible IRA to a Roth IRA. There is no income limitation on a conversion of a non-deductible IRA to a Roth IRA, so what you can’t do directly, you can accomplish indirectly. Your contribution is now in a Roth IRA, via the non-deductible IRA.
The Benefit (and Caveat)
Once you have converted your funds to a Roth IRA, you will not pay taxes on any portion of the withdrawal. However, there are a few traps to watch for—for example, if you convert a nondeductible IRA to a Roth, any other IRA(s) you have is considered converted on a pro rata basis, and that could create ordinary income. It’s best to check with a professional before pursuing this strategy to ensure the risk of an added tax burden does not outweigh the benefits of a Roth conversion.
There are many other meaningful ways to stretch your dollar in our new e-book: 12 (More) Great Ideas. Do you have a question about how this information applies to you? Email Jim Sacher, CPA or call him at 440-449-6800.