Digging Deeper Into Your IRA

36212286_lMany reading this article may think IRAs are relatively straightforward, the tax laws surrounding them are black and white, and the rules are clear. But sometimes things are not as straightforward as they seem at first glimpse.
Although the basic IRA guidelines appear to be simple, in order to take advantage of all that these accounts have to offer, you need a deeper understanding of the rules. You need to climb down the rabbit hole. It may seem scary, but learning about the more complex rules can make a difference of tens of thousands of dollars down the road.
Some of those lesser-known and more complicated rules involve a type of Roth Conversion, referred to as “Backdoor Roths.” First, let’s do a quick review of Roth IRAs. A Roth IRA does not allow for any tax deduction in the year a contribution is made (unlike with a Traditional IRA), but all distributions are tax-free. This is extremely important—your money grows and all the growth comes back to you free from Uncle Sam’s greedy hands. With a Roth IRA, you can withdraw your contributions at any time without taxes or penalty (withdrawal of any earnings prior to age 59 1⁄2 can lead to penalties). Most importantly, Roth account holders are never forced to take those nasty Required Minimum Distributions, like Traditional IRA account holders are required to at age 70 1⁄2. The challenge with the Roth comes into play with those darn income limits.
For married folks, if your Modified Adjusted Gross Income (MAGI) is less than $183,000 and you are under the age of 50, you can contribute $5,500 per year to a Roth (to the extent you have earned income). If you are over the age of 50, the contribution limit increases to $6,500 (again, to the extent you have earned income). The amount you can contribute is phased out if you earn between $183,000 and $193,000. Single filers can contribute to a Roth if MAGI is less than $116,000. That contribution limit is phased out between $116,000 and $131,000. If you are married and earn more than $193,000 or single and earn more than $131,000, well, Uncle Sam thinks you should not be able to take advantage of Roth IRA benefits.
Those income limits can prevent a lot of people from contributing to a Roth. So if you fall within any of those ineligible income windows, should you hang your head, let out an “awe shucks” and walk away?
Hmm. Not so fast.
If you are content to look at the guidelines for contributing to a Roth IRA at face value, without looking any further, then yes, go ahead and do that. If you want to take a deeper look, don’t be so quick to give up.
For all the rules surrounding contribution limits based on income, there is no limit on how much money you can convert from a traditional IRA to a Roth IRA. Here comes the “back door.” Let’s say you and your spouse make a combined $200,000 of income and you do not participate in any employer-sponsored retirement plan. If you want to contribute $5,500 directly into each of your Roth IRAs to create a future tax-free pot of money, you are not allowed to, but that does not make it impossible to fund your Roth IRA. It just takes two more steps.
Step one to implementing a Backdoor Roth is to open a traditional nondeductible IRA. (There are just two requirements to be able to make a contribution to a traditional nondeductible IRA. First, you must have earned income. And secondly, you cannot be age 70 1⁄2 or older at the end of the year. There are no income limits and the ability to contribute is not affected by any employer-sponsored retirement plan that you might be participating in.) Step two, make your contribution to that IRA.
The final step is to roll over that money from the traditional nondeductible IRA to your Roth IRA. You will owe ordinary income tax on the full amount converted to your Roth IRA.
Now, if you were to make the contribution to a traditional IRA already funded with pre-tax money, things would get more complicated due to the Pro Rata rule, which states that, in general, an IRA distribution, which includes any amounts rolled into a Roth IRA, consists of the same proportion of pre-tax and after-tax dollars as the IRA owner has in his or her IRA(s). How does this rule make things tricky? Here’s an example.
Bob (who is single) has $95,000 in his traditional IRA, all of which is pre-tax, or another phrase I like to use is “tax-infested.” Recently, Bob’s financial circumstances changed. He is now earning more than $131,000 so, technically, he cannot contribute to a Roth IRA. If Bob makes a $5,000 nondeductible (after-tax) contribution to a Traditional IRA funded with pre-tax money, his total IRA balance will be $100,000, $5,000 of which will be after-tax. Thus, only 5 percent ($5,000 / $100,000 = 5 percent) of any distribution Bob takes—including any amounts rolled into his Roth IRA—will be a tax-free return of his after-tax amount. Stay with me here; so if Bob were to convert $5,000 from his traditional IRA to a Roth IRA, after making his nondeductible contribution, just $250 would be tax-free ($5,000 multiplied by 5 percent), while the remaining $4,750 ($5,000 minus $250 equals $4,750) would be taxable. That’s probably not what Bob had in mind.
My point is that IRAs (both traditional and Roth) play important roles in retirement planning. They may seem simple on the surface, but I urge you not take the easy road. Simple isn’t always better. Don’t settle for simple, dig into the rules, ask questions and make sure you are getting the most from the strategies available to you. And remember, seek guidance from a retirement specialist so you can have the clarity you deserve.