Because there are income limits to open a Roth IRA, most people earning high salaries don't believe a Roth IRA is an option. Under the law, a single person with an annual adjusted gross income of $133,000 or more and a married couple making more than $196,000 cannot directly fund a Roth IRA.
However, since an Internal Revenue Service rule change in 2010, there have been no income limits on converting funds initially made to traditional IRAs into Roth IRAs. By taking advantage of this strategy, many people can implement a long-term strategy to have more tax-free funds available in retirement.
Here's how this "back door" Roth IRA strategy works:
Most high earners are likely saving the maximum allowed in company 401(k) plans. After all, it's an easy way to save and consistently invest money that will grow over time, but there is a limit to these contributions. The ceiling for 2016 before-tax contributions is $24,000 for people age 50 and older. So how can a person save more and reduce their taxes?
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The first step is to open an after-tax "non-deductible" traditional IRA and, if you are married, one for your spouse, too. Anyone is eligible to open a non-deductible IRA, even if contributing the maximum to a company 401(k) plan. For example, a person earning $300,000 annually who participates in his or her company's 401(k) plan can open a non-deductible IRA and contribute up to $5,500 annually, or $6,500 if over age 50. If married and both spouses are age 50 or older, they can contribute a combined $13,000.
Once the after-tax IRA has been set up, the second step is to convert it into a Roth IRA.
People setting up a new after-tax IRA should consult with a financial advisor on how quickly this account can be converted into a Roth IRA. If the account can be converted quickly, any taxes owed could be minimal. The more time between the initial contribution and conversion to a Roth IRA, the more likely these funds will generate a gain. If this occurs, taxes will be due on the gains.