What is a Roth IRA?
“Life is not getting cheaper for millions of American families … it’s only fair to let them keep more of their hard-earned money,” said Senator William Roth, main voice behind the now famous Roth IRA. Most of us have run across the several different options for an IRA – which can be as confusing as they are overwhelming.
The Roth IRA is formally defined as: “…a special retirement account that you fund with post-tax income (you can’t deduct your contributions on your income taxes). Once you have done this, all future withdrawals that follow Roth IRA regulations are tax free.” As opposed to the traditional IRA, your initial contribution money is taxed and your later withdrawals are tax free. Traditional IRAs work in exactly the opposite way.
Back-Door Roth IRA Conversion Strategy
One disadvantage with Roth IRAs is an income ceiling on who can start one. For example, as a single person, you have to make less than $135,000 a year in order to even have a Roth. A second limitation is the limit on contributions to a Roth.
The work-around for these limitation is what’s called a “backdoor Roth IRA conversion strategy,” in which a traditional IRA is converted into a Roth IRA, thus enjoying the advantages of both systems. There are limitations on contributions to Roth IRAs, but there are no limitations on Roth conversions, nor is there an income ceiling.
The backdoor Roth IRA conversion strategy was recently confirmed by the Tax Cuts and Jobs Act as an allowable approach. The conference agreement states in footnote 268: “Although an individual with AGI exceeding certain limits is not permitted to make a contribution directly to a Roth IRA, the individual can make a contribution to a traditional IRA and then convert that traditional IRA to a Roth IRA.”
This means that high-income taxpayers can make non-deductible contributions to traditional IRAs and then convert those traditional IRAs to Roth IRAs (the pro-rata rule will apply). Let’s look at three things to remember when employing this strategy.
You have to have earned income in the year you want to make a contribution to a Roth. Earned income is defined as “ … money paid for work you performed (or in the case of a small business, profit distributions from the business).”
This income includes wages, salaries, tips, bonuses, commissions and self-employment income” and a few other instances. Earned income does NOT include things like dividends paid from investments and pension payments.
You can’t be over age 70 ½, as traditional IRA contributions can no longer be made after this age. Remember also that the money converted into the Roth is not considered a contribution, but converted funds. This means if you are under 59 ½, you have to wait 5 years to access that money penalty-free. If the funds were simply traditional IRA contributions, you could access them immediately, tax and penalty-free.
Alan Hopkins, Chief Economic Strategist at Manchester, pointed out: “Similar to Social Security, the IRA system runs on age – sometimes even fractions of a year – and avoiding penalties is a matter of correct timing.”
The Pro-Rata Rule
The pro-rata rule will apply when doing the backdoor Roth IRA conversion strategy. All your IRAs, including SEP and SIMPLE IRAs, are included in the pro-rata calculation. This could mean that some of your back-door Roth conversion will be taxable if you have other pre-tax funds in any of your IRAs.
That’s still not a bad thing because that tax would have been paid anyway eventually, and now you’re getting more money growing tax free in your Roth IRA.
Let it Ride!
However you contribute to your retirement fund, whether the backdoor Roth IRA conversion strategy or another approach, remember the end goal is to let that money compound tax-free for a long time. Let it ride – leave the money in place and let it continue to grow, despite the whims of the market or the latest investment rumors.
“Creatively, strategically engaging with your money is the way to grow it – not throwing it after hot stocks or hiding it under the proverbial mattress,” said Robert Katch, President and CIO of Manchester Financial.