Most individuals are familiar with the benefits and contribution eligibility of a traditional IRA, and many are familiar with Roth IRAs, but to a lesser extent. The two are similar in terms of being retirement plans, but they are vastly different in terms of taxes.
While contributions to a traditional IRA are generally tax-deductible, the distributions received from a traditional IRA are generally taxable. Alternatively, contributions to a Roth IRA are generally NOT tax-deductible, and the distributions from a Roth IRA are NOT taxable. However, in both cases, the assets in either IRA grow tax-free.
Due to the tax-free growth and tax-free distributions, the Roth IRA has become a very attractive investment vehicle. However, the IRS has implemented stipulations that “prevent” high-income earners from making Roth IRA contributions. For single taxpayers, Roth IRA contributions are phased out when Modified Adjusted Gross Income (Modified AGI) is equal to or greater than $131,000. For taxpayers married filing joint, Roth IRA contributions are phased out when Modified AGI is equal to or greater than $193,000.
On the surface, it appears high-income earners lose the ability to contribute to the Roth IRA. However, you will learn that is not the case. A loophole in the Internal Revenue Code allows high-income earners to make non-deductible contributions to a traditional IRA immediately followed by a Roth IRA conversion (commonly referred to as a Backdoor Roth conversion).
Generally speaking, converting funds from a traditional IRA to a Roth IRA creates a taxable event for the taxpayer. If traditional IRA funds were previously deducted from income, a taxpayer would pay tax on the entire amount converted at their ordinary income tax rate in the year of conversion. From there, Roth IRA rules would apply in terms of tax-free growth and tax-free distributions.
Since some high-income taxpayers are not eligible to take an IRA deduction due to income levels and/or their employer-sponsored retirement plan, this Backdoor Roth conversion can be a valuable tool. As long as you have no other IRA accounts, treating an IRA contribution as non-deductible can prevent the conversion from being a taxable event – since the contributions were never deducted. That same day, the non-deductible IRA contribution can be converted to a Roth IRA, allowing high-income earners the ability to use the Roth IRA as a retirement vehicle.
While the above generally reflects appropriate advice, it is important to discuss the ability to utilize Backdoor Roth conversions with an Anders tax advisor.
