High Income? Here’s How You Open A Roth
First made available to investors in 1998, Roth IRAs introduced a whole new structure for tax-deferred saving. Until then, investors could make tax-deductible contributions to traditional IRAs and 401(k)s. Roth accounts allowed tax-free distributions.
Many of our clients want to take advantage of both ways of saving for retirement.
The problem: Roth accounts have income limits.
In 2013, single filers making more than $127,000 in adjusted gross income, and married couples making more than $188,000, are not allowed to contribute to Roth IRAs.
The question: If I – or my spouse and I – are above the income limits for Roth IRAs this year, can I still Roth?
The answer, fortunately, is yes…if you know how.
As I wrote in my earlier post on Roth 401(k) accounts, there are no income limits barring participation in Roth 401(k) programs. If your company offers it, you can take advantage of it.
Roth 401(k) accounts have the same contribution limits that their traditional 401(k) cousins have: a generous $17,500 for 2013 ($23,000 if you are over 50).
Unlike contributions to traditional 401(k) accounts, contributions to a Roth 401(k) are not tax deductible. However, when you leave the company, you can roll over your Roth 401(k) into a Roth IRA and pay no additional taxes.
One side note for the self-employed and entrepreneurs: A number of investment companies, like Vanguard, offer Individual Roth 401(k)s. (These services advertise a total contribution limit of $51,000 in 2013, which includes both employer and employee contributions. Employee contributions are limited to the same $17,500, just as they are in a corporate 401(k). All employer contributions must be made into a traditional 401(k) account.)
Option 2: The Backdoor Roth IRA
A small handful of our clients might benefit from using a “backdoor” Roth IRA; some young people use the backdoor Roth IRA option every year, because they’ve decided that the advantages of the Roth (the tax-free distributions) outweigh the issue I’m about to outline below.
There is a catch to a backdoor Roth IRA: The IRS aims to tax some of the money you convert.
The concept for the backdoor Roth IRA emerged inauspiciously a decade ago. In 2003, the IRS began to phase out the Roth IRA income limit for people who wanted to convert their old, traditional IRAs into the new Roth format. Previously, people who could not make contributions to a Roth IRA because they made too much money, also could not convert a traditional IRA to a Roth IRA.
By 2010, the contribution limit was phased out completely. Since then, there has been no income limit for taxpayers who want to convert their traditional IRAs to the Roth format.
Thus, the backdoor Roth IRA was born.
Put simply, if you are over the income limit to open or contribute to a Roth IRA, you can still open a traditional IRA and then convert it to a Roth IRA. (It’s assumed that you will not attempt to take a tax deduction on the initial contribution to the traditional IRA, since you are also above the income limits for taking that deduction.)
Seems too good to be true? Well, it is, at least if you already have a traditional, deductible IRA. When you convert from a traditional IRA to a Roth IRA, the amount you convert is taxed by the proportion of all of your traditional IRAs funded by pre-tax contributions.
Let’s say you have a traditional, deductible IRA valued at $10,000, and this year you plan to contribute $5,000 to a traditional, non-deductible IRA to convert to a Roth account.
The way the IRS looks at it, you have $15,000 in IRA assets, 66.7% of which are deductible.
If you convert the $5,000 account to Roth, the IRS will require you to pay taxes on 66.7% of that amount, or $3,333.
Given the complexities, if you have existing traditional IRA assets, consider the tax consequences carefully. You should consult with a tax accountant about your particular situation before pursuing a backdoor Roth IRA.
We believe having a balance of Roth and traditional retirement assets gives you more flexibility in managing your taxes in retirement.
Thanks to the Roth 401(k) and Roth IRA conversions, individuals fortunate enough to have high income this year still have options to acquire and build Roth assets.
Nothing in this communication should be construed as an offer, recommendation, or solicitation to buy or sell any security. Wealthfront’s financial advisory and planning services, provided to investors who become clients pursuant to a written agreement, are designed to aid our clients in preparing for their financial futures and allow them to personalize their assumptions for their portfolios.
This blog is not intended as tax advice, and Wealthfront does not represent in any manner that the outcomes described herein will result in any particular tax consequence. Prospective investors should confer with their personal tax advisors regarding the tax consequences based on their particular circumstances. Wealthfront assumes no responsibility for the tax consequences to any investor of any transaction. Investors and their personal tax advisors are responsible for how the transactions in an account are reported to the IRS or any other taxing authority.
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Adam Nash, Wealthfront's CEO, is a proven advocate for development of products that go beyond utility to delight customers. Adam joined Wealthfront as COO after a stint at Greylock Partners as an Executive-in-Residence. Prior to Greylock, he was VP of Product Management at LinkedIn, where he built the teams responsible for core product, user experience, platform and mobile. Adam has held a number of leadership roles at eBay, including Director of eBay Express, as well as strategic and technical roles at Atlas Venture, Preview Systems and Apple. Adam holds an MBA from Harvard Business School and BS and MS degrees in Computer Science from Stanford University.
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- 1.What Is a Backdoor Roth IRA? | RothIRA.com
Description: A backdoor Roth IRA allows you to get around income and contribution limits by converting a Traditional IRA into a Roth IRA.
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Description: Roth IRA Conversion Taxes. When you convert from a Traditional IRA to a Roth IRA, a process also known as creating a “backdoor” Roth IRA, you generally pay income .
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Description: Jan 20, 2012 · If your income is too high, you can’t contribute directly to a Roth individual retirement account, but you can get one in a backdoor way. Step 1: Open a .
Description: Mistake 1: Not Paying Attention to the Pro-Rata Rule If you've heard about any sort of hitch with a backdoor Roth IRA, you've probably heard about the pro-rata rule.
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