Backdoor Roth IRAs: Potential Way for High Income Earners to Participate!



The traditional contribution ("front door") for Roth IRAs is currently not available for higher income earners. Married couples earning $191,000 or more and singles earning $129,000 or more in 2014 are still barred from contributing directly to Roth IRAs.

In 2010, Congress changed the rules and since then anyone can convert a traditional IRA to a Roth IRA. However, higher income earners are still ineligible to contribute to a Roth IRA.

A Backdoor Roth IRA is a strategy for some higher income earners to participate in Roth IRAs.  It is a way for higher income earners to put money into a traditional IRA and then roll that into a Roth IRA, getting all the benefits.  While this strategy sounds simple, there are several rules that you must know and follow to make sure you do not incur unintended tax consequences.  This is where working with a knowledgeable financial or tax professional can provide some great guidance and value.
  
One of the primary benefits of a Roth IRA is that any money contributed grows tax-free and is withdrawn without any further income taxation. In addition, unlike a traditional IRA, Roth IRAs have no required lifetime minimum distributions. Another benefit of a Roth IRA is it can be passed on to your heirs income tax free. This allows your funds to grow and compound tax free over many years.

How Does the Backdoor
Roth IRA Conversion Work?

The backdoor Roth conversion consists of two simple steps:
  1. You make a nondeductible contribution to your traditional IRA.
  2. Within a couple of days you convert this IRA into a Roth IRA (potentially paying little to no taxes on the conversion).


There's one big caveat: This strategy works best tax-wise for people who don't already have money in traditional IRAs. That's because in conversions, earnings and previously untaxed contributions in traditional IRAs are taxed—and that tax is figured based on all your traditional IRAs, even ones you aren't converting (Please read the section on the Pro Rata Rule).

For an investor who doesn't already hold any traditional IRAs, creating one and then quickly converting it into a Roth IRA will incur little or no tax, because after a short holding period there's likely to be little or no appreciation or interest earned in the account.  However, if you already have money in traditional deductible IRAs, you could face a far higher tax bill on the conversion (again, this is covered later in the section on the Pro Rata Rule).
If you choose to, you can contribute to a non-deductible IRA for 2014 (the maximum is $5,500 or $6,500 for those age 50 or older). Remember, you must contribute to your IRAs prior to the April 15 2015 tax deadline. This non-deductible IRA can then be used for your backdoor Roth IRA conversion (please call us prior to doing so because the rules for Roth conversions can be complicated).


Example of a Backdoor Roth IRA

Bill's Backdoor Roth IRA Conversion without Additional IRAs
Contribution to
Non- deductible traditional IRA
Convert to Roth IRA
Income Subject to Taxation
$5,500
$5,500
$0

Bill, a high income earner decides on January 2nd to put $5,500 into a traditional IRA for himself and another $5,500 into a traditional IRA for his wife Mary. Bill's income is too high to be able to deduct these contributions from his taxes. So the next day, he converts the traditional IRAs to Roth IRAs completely tax-free. His income is too high for him to make a direct contribution into a Roth IRA, but there’s no income limit on conversions! Since Bill and Mary couldn’t deduct the contribution anyway, they might as well get the advantage of never paying taxes on that money again available through the Roth IRA.


Beware of the Pro Rata Rule for Roth Conversions

What is the Pro Rata rule for Roth conversions?

The Pro Rata rule for Roth conversions states that if you have any other deductible IRAs (i.e. a previous 401k that you’ve rolled over), the conversion of any contributions becomes a taxable event that you’ll need to pay taxes on upfront.

The Pro Rata rule for Roth conversions determines whether or not your conversion will be taxable! For taxation purposes, the IRS will look at your entire IRA holdings (even if they are in different accounts), not just the traditional IRA you are converting to a Roth IRA, and will determine what your tax bill will be based upon a ratio of IRA assets that have already been taxed to those IRA assets in total.

The IRS determines the tax on this conversion based on the value of all of your IRA assets. For example Jane, a high income earner, already has $94,500 in an IRA account, all of which has never been taxed. She decides on January 2nd to put $5,500 into a new traditional IRA. The next day she converts the new traditional non-deductible IRA to a Roth IRA. Jane’s income is too high for her to make a direct contribution into a Roth IRA, but there’s no income limit on conversions. Unlike Bill she has $94,500 in other IRAs (previously non-taxed), so her total IRA assets are now $100,000. When she converts $5,500 to a Roth IRA, the IRS pro-rates her tax basis on the previous taxation of her total IRA assets, therefore making this conversion 94.5% taxable ($94,500/100,000 = 94.5%).

Jane's Backdoor Roth IRA Conversion
Balance in All IRAs
Contribution to Non-deductible traditional IRA
Convert to Roth IRA
Income Subject to Taxation
$94,500
$5,500
$5,500

$4,750




So if you plan on using this backdoor IRA strategy, you want to be clear as to whether or not you have any other IRAs. As you can see, this can be a confusing area and this is where we can help.  If you are a high income earner we would be happy to review your situation to determine if this strategy is in your best interest.

Also, please remember that your spouse’s IRA is separate from yours.

Benefits of a Roth IRA


There are numerous benefits to converting to a Roth IRA. Please remember, it is important to review all of your retirement accounts before converting to a Roth IRA. Some benefits of a Roth IRA include;
  • Required minimum distributions are not obligatory until the participant’s death.
  • Withdrawals are tax free.
  • They pass onto your heirs income tax-free.
  • You can compound your investments in a tax-free fashion.


Am I a Candidate for a
Backdoor Roth IRA?

Backdoor Roth IRAs can be appropriate for investors who:

·         Only have retirement account through their jobs (i.e. 401k's) and want to increase their retirement savings in tax-advantaged accounts, but whose income is too high to qualify for standard Roth IRA contributions; and

·         Have the time and ability to wait for five years or until they are 59 ½ to avoid the 10% penalty on early withdrawals. (If you open and make contributions to a Roth IRA in the standard manner, i.e. not through conversion, you are not subject to this rule).

A Backdoor Roth IRA is probably not recommended if you:

·           Are over the age of 70½  and can no longer contribute to a traditional IRA.

·           Don’t want to contribute more than the maximum retirement limit through your workplace retirement account.

·           Already have money in a traditional IRA and because of the Pro Rata rule may end up in a non-tax advantageous position when converting to a Backdoor Roth IRA.

·           Plan or expect to withdraw the funds in the Roth IRA within the first five years of opening it. A Backdoor Roth is considered a conversion and not a contribution. Therefore, the funds will incur a 10% penalty if withdrawn within five years unless you are age 59 ½ or older.

·           Are in a high tax bracket now and expect to be in a lower tax bracket in the future.

·           Plan to relocate to a lower- or no- income tax state.
Recharacterizations

Converting to a Roth IRA also comes with another very unique advantage.  The IRS allows you a one-time opportunity to recharacterize or "undo" this conversion by October 15th of the following tax year. IRS publication 590 states that, "a recharacterization allows you to ‘undo’ or ‘reverse’ a rollover or conversion to a Roth IRA. To recharacterize, you generally instruct the trustee of the financial institution holding your Roth IRA to transfer the amount back to a traditional IRA (in a trustee-to-trustee or within the same trustee). If you do this by the due date for your tax return (including extensions), you can treat the contribution as made to the traditional IRA for that year (effectively ignoring the Roth IRA contribution)".  In the case of a Backdoor Roth IRA, you probably won’t think about recharacterizing. However, if you want to explore this option, we are here to help assist you, because like many of the other rules involved this can be complicated.

Conclusion

While Backdoor Roth IRAs can be beneficial to many investors, they aren’t for everyone. They come with their limitations and complications. There are precautions that need to be taken to reap the full benefits of any financial decision. This is an area where a highly informed financial advisor can help you make an educated and calculated decision. You should always consult with your financial advisor and tax professional to help avoid tax ramifications.

GFS & Associates Day - June 15, 2014

June 15, 2014 is GFS & Associates Day!

Mayor Carolyn Goodman recently honored us for serving Las Vegas and the surrounding communities for over 30 years. We are very proud of this achievement and believe it shows our continued commitment to financial planning and our clients.


Time is Money!

I am often asked, "When is the best time to start financial planning?" In my opinion, there are two best times to start. The first is when you get your first job. If you can learn to live without 10% of your income starting day one, you will be able to save lots of money and watch it grow.

The second best time to start financial planning is right now. If you missed the first best time, and unfortunately most people to, starting today is better than tomorrow. The more time you have between today and the day of your retirement, the more your money can grow.

People who start saving early have a distinct advantage - compound interest. Earning interest on your interest can have a tremendous impact on your growth rate.

Here is an example with two people, Tom and John. Tom starts saving early, putting away $2,000 a year for 10 years starting at age 21. Then he lets the money continue to grow until 65. John wants to wait. He starts at age 31 putting away $2,000 and continues doing so until age 65. They both invest in the same hypothetical investment that earns 8%. Tom's total contribution is $20,000, Johns is $70,000. Who ends up with the most money?



Age
Tom Contribution
Tom's Total
John Contribution
John's Total
21
$2,000
$2,000
$0
$0
22
$2,000
$4,160
$0
$0
23
$2,000
$6,493
$0
$0
24
$2,000
$9,012
$0
$0
25
$2,000
$11,733
$0
$0
26
$2,000
$14,672
$0
$0
27
$2,000
$17,846
$0
$0
28
$2,000
$21,273
$0
$0
29
$2,000
$24,975
$0
$0
30
$2,000
$28,973
$0
$0
31
$0
$31,291
$2,000
$2,000
32
$0
$33,794
$2,000
$4,160
33
$0
$36,498
$2,000
$6,493
34
$0
$39,418
$2,000
$9,012
35
$0
$42,571
$2,000
$11,733
36
$0
$45,977
$2,000
$14,672
37
$0
$49,655
$2,000
$17,846
38
$0
$53,627
$2,000
$21,273
39
$0
$57,917
$2,000
$24,975
40
$0
$62,551
$2,000
$28,973
41
$0
$67,555
$2,000
$33,291
42
$0
$72,959
$2,000
$37,954
43
$0
$78,796
$2,000
$42,991
44
$0
$85,100
$2,000
$48,430
45
$0
$91,908
$2,000
$54,304
46
$0
$99,260
$2,000
$60,649
47
$0
$107,201
$2,000
$67,500
48
$0
$115,777
$2,000
$74,900
49
$0
$125,039
$2,000
$82,893
50
$0
$135,042
$2,000
$91,524
51
$0
$145,846
$2,000
$100,846
52
$0
$157,514
$2,000
$110,914
53
$0
$170,115
$2,000
$121,787
54
$0
$183,724
$2,000
$133,530
55
$0
$198,422
$2,000
$146,212
56
$0
$214,295
$2,000
$159,909
57
$0
$231,439
$2,000
$174,702
58
$0
$249,954
$2,000
$190,678
59
$0
$269,951
$2,000
$207,932
60
$0
$291,547
$2,000
$226,566
61
$0
$314,870
$2,000
$246,692
62
$0
$340,060
$2,000
$268,427
63
$0
$367,265
$2,000
$291,901
64
$0
$396,646
$2,000
$317,253
65
$0
$428,378
$2,000
$344,634

It is amazing that Tom contributed $50,000 less, but came out with $83,744 more at the end. He just started 10 years earlier. Albert Einstein put it best when he said “Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it.”

When you chart the value of an account growing with compound interest, it always starts out rather flat in the early years. At time goes on, it starts growing at a steeper and steeper rate. Check out this chart:


This chart shows what would happen if somebody saved $2,000 a year starting at age 21 and the account grew at 8%. As you can see towards the end of the graph, the difference between the years is growing significantly. There is a difference of about $63,800 in the last year alone! Thank you compound interest!

Compound interest doesn't care how rich or how poor you are. It works the same for everybody. The growth rate on this graph would be the same for annual contributions of $200, $2,000, or $20,000. Obviously numbers on the left side of the graph would change, but the slope would remain the same.

Unfortunately, compound interest discriminates on age. Everybody starts at the same place - the left - on this graph. It doesn't matter if you are 21, 45, or 70, you always start at the left where the money isn't growing quickly. The younger you are when you start, the farther you will go to the right. If you start at age 45, you would have to save to age 90 to get to the same end point on this graph.

Compound interest can work against you. You may think, "How can that be, Mike? You just said it was really great!" It works against you when you are borrowing money, especially on credit cards. If you bought a $2,000 TV on a credit card charging 15% interest over 2 years, you would end up paying a total of $2,327.28 for it. Oops.

Is time really equal to money? In this case it is. The earlier you start saving money, the more it can grow. If you are a parent, this is one of the most important financial lessons you can your child.

Are you wondering if you can really afford to save money? I ask, "How can you not?" I like to have people go through a cash flow analysis to look for money they can reallocate to savings. You can access our cash flow analysis form by clicking here.