As Benjamin Franklin once said: “In this world nothing can be said to be certain, except death and taxes.” Franklin’s right. As an investor, you’ll be paying taxes. But there are strategies to reduce how much you’ll pay, and that can make a big difference in the size of your portfolio when you retire.
In Roth Individual Retirement Accounts (or IRAs), you pay taxes when you invest the money in the account. But when you take the money out in retirement, you can take out all the money — including the untaxed earnings — without paying any further taxes. The longer you have until retirement, the more you’ll save.
It’s a great benefit, and if you make below $116,000 filing as single, or $183,000 filing as married filing jointly, you can contribute directly to a Roth IRA. But if you make more than these amounts, your tax benefit is reduced and even eliminated completely.
As an aside: If you make less than $71,000 filing as single or $118,000 filing as married, you can deduct some amount of your contributions to a Traditional IRA, where you defer all taxes until retirement. If this is you, this might be a better choice. Likewise, if you’re investing a smaller amount of money and you still have room to contribute tax-deferred money in a qualified retirement account like a 401(k), that might be a better choice.
But if you make more than the limit, it’s still possible to put money into a Roth IRA. In 2010, the tax code changed creating a loophole where higher earning savers can still contribute to a Roth IRA through a backdoor Roth conversion, where money is rolled over from a traditional IRA into a Roth IRA. Proceed with caution as some believe the IRS could treat this strategy as a step transaction.
It’s a bit more complicated, but the tax savings are worth the effort. Here’s how a backdoor Roth conversion works.
Step One: Place Tax-Deferred, Deductible Money in Your Traditional IRAs
The first step in the process is to make sure you only have nondeductible money in your IRA (money you’ve already paid tax on). Why is this necessary? If you have a mix of deductible contributions and nondeductible contributions, you’ll be taxed according to the ratio of IRA assets that have been taxed vs those that have not.
If you have $20,000 in tax-deferred contributions (say, from a previous employer’s 401(k)), and $5,000 of new nondeductible contributions, when you try to rollover the $5,000 you’ll be taxed at $20,000/$25,000 or 80% of the amount. That means $4,000 of the $5,000 contribution would be taxed. You can’t selectively rollover just the nondeductible contributions.
If you don’t have any tax-deferred IRAs like a traditional IRA, SEP-IRA or SIMPLE IRA, this step is simple. You can proceed to the next step. If you have a minimal amount of deductible contributions, and you don’t mind paying the minimal amount of tax, you can also proceed to the next step.
If you have considerable tax-deferred, deductible assets in your traditional IRA, you’ll want to transfer those assets into a different plan. Many employer 401(k) plans accept rollovers; that can be a great option. It’s also possible to open a solo 401(k) if you have a small side business.
When you transfer the assets, make sure to transfer only the deductible, tax-deferred contributions to abide by the IRS guidelines. Leave a little buffer in the traditional IRA if necessary.
Step Two: Make Your Non-Deductible Contribution
At this point, you should either:
- Not have a traditional IRA, SEP-IRA or SIMPLE IRA
- Have a traditional IRA with only non-deductible contributions
It’s time to make your non-deductible contribution to the traditional IRA. As long as you have earned income, you are eligible to make the contribution. There are not any income limits. The maximum contribution per person for 2015 is $5,500 for those under the age of 50, and $6,500 for those over 50.
Step Three: Put the Money in Cash
In order to avoid being taxed on the money, you’ll want to make sure that you don’t have any earnings on the money. The easiest option is to leave the money in a money market account or some time of cash fund.
Step Four: Wait A Bit, But Not Too Long
In order to get documentation of the funds in your traditional IRA account, wait a month until you receive a statement from your IRA provider. The law doesn’t specify a set waiting period between a contribution and a conversion, but many industry experts recommend a small wait between the two steps.
It’s also important to make sure that the entire transaction to be finished by the end of the calendar year.
Step Five: Convert the Funds from the Traditional IRA to Your Roth IRA
Once you receive your statement, it’s time to roll the funds from your traditional IRA to your Roth IRA. Once again, you’ll want to make sure you complete the entire transaction by the end of the calendar year.
Step Six: Report on Your Tax Return
Come tax time, you’ll want to make sure you document the whole transaction by including Form 8606 in your tax return. You report on both making the non-deductible contribution to the traditional IRA and on converting to the Roth in the same year.
It’s possible to do in separate years, but make it easier on yourself by completing the transaction. It’s not complicated to document the transaction as even tax software like TurboTax or TaxACT will help you fill out the appropriate forms.
Step Seven: Do It Again
If you are investing regularly, a $5,500 contribution isn’t going to make up a large portion of your portfolio. In order to really take advantage of the Roth IRA, you’ll want to repeat the process every year. Over time, this will add up to a more significant amount of tax savings and diversification.
A backdoor Roth conversion is a great option for higher income earners to minimize their tax burden, especially once other tax-advantaged options like 401(k)s are no longer available. Many people take advantage of this process every year. You can be one of them.