Know your options for retirement accounts
The short answer is that unfortunately, if you are indeed over the income limits, then you are not eligible to contribute to a Roth IRA. However, stick around for the long answer as I think you will like where it takes us.
Many people earning high incomes do not believe that a Roth IRA is an option. There is however a great strategy that they could be overlooking that may save them significant tax dollars in retirement. As you alluded to, under the law a married couple making more than $196,000 in adjusted gross income (AGI) cannot contribute directly to a Roth IRA. For singles, that number is $133,000. For those eligible to contribute, the 2017 maximum contribution is $5,500 unless you will be age 50 or older by Dec. 31, in which case the maximum is $6,500. Roth IRAs are attractive for several reasons. While they are funded with after-tax dollars, any earnings are tax-deferred and withdrawals in retirement are taxfree.” Additionally, Roth IRA’s are not subject to the minimum annual withdrawals required from traditional IRAs during retirement, which makes them an excellent taxplanning tool.
There are three ways a Roth IRA can be funded. You can contribute directly (though in your case we have already determined you are probably not eligible), you can convert all or part of a traditional IRA to a Roth IRA, or you can roll funds over from an eligible employer retirement plan. It is the conversion option that allows us a workaround for the income limits to Roth IRA contributions. This is sometimes referred to as a “back door” Roth iRA.
Since 2010, an IRS rule change removed income limits on converting funds initially made to traditional IRAs into Roth IRAs and allows for our Roth IRA funding strategy. The strategy works like this: First open an after-tax, non-deductible traditional IRA, and if you’re married, one for your spouse too. Anyone under the age of 70 1⁄2 is eligible to open a non-deductible IRA (even if you are already contributing the maximum to a company 401(k) plan). Keep in mind that the contribution limits for the non-deductible traditional IRA are the same as that of the Roth IRA ($5,500 annually if under age 50, and $6,500 annually if age 50 or over). As a result, if married and over age 50, a couple could contribute a combined $13,000 per year. Once the after-tax IRA has been set up, the next step is to convert it into a Roth IRA. The custodian/trustee of your nondeductible traditional IRA can assist you with the necessary paperwork.
This is a strategy that can be applied year after year and if done over a long period of time can result in a significant source of tax-free retirement income.
As with most strategies, there are circumstances where this strategy works well and there are others where it doesn’t. If you have made only nondeductible (after-tax) contributions to your traditional IRA, then only the earnings, and not your own contributions would be subject to tax at the time you convert to a Roth IRA. However, if you have other IRAs, SEP-IRAs, or SIMPLE IRAs, they most likely were funded at least partially with pre-tax contributions and upon conversion would incur taxes and therefore make the strategy less appealing. Keep in mind, even though these pretax accounts may be separate from your after-tax accounts, the IRS requires that you aggregate all of your traditional IRAs, SEPs and SIMPLEs for purposes of calculating the taxable portion of your conversion. Another critical factor is how quickly the custodian/trustee of your nondeductible traditional IRA can convert the account to a Roth IRA. The less time it takes to convert, the less chance there is for gains in the non-deductible traditional IRA. Since gains are taxable upon conversion, this would also make the strategy less appealing. You can see that this strategy has the potential to be very beneficial to high-income earners, but it can get a little complicated depending on your circumstances. Therefore it is recommended that you consult with a qualified tax advisor before making any decisions.
*Unless certain conditions are met, Roth IRA owners must be 59 1⁄2 or older and have held the IRA for five years before tax-free withdrawals are permitted. Additionally, each converted amount is subject to its own five-year holding period.