If you think a certain type of well-known tax-free retirement account is beyond your reach because you earn too much, think again.
Roth individual retirement accounts allow savers to put away up to $5,500 (or $6,500 if you are age 50 or older), have the money grow free of taxes and then tap it in retirement on a tax-free basis.
Yet Roth IRAs aren't available to everyone: Filers whose modified adjusted gross income exceeds $120,000 if single (or $189,000 for joint filers) are currently unable to make a full contribution directly to a Roth IRA.
Instead, those individuals can use a strategy known as the “backdoor Roth.”
In this case, a saver would make a nondeductible contribution with after-tax dollars to a traditional IRA account and convert it to a Roth. This conversion would be free of income taxes in most cases.
“A lot of people have been concerned about using this strategy and uncertain about how the IRS would treat it,” said Bob Phillips, a CPA and managing principal of Spectrum Management Group in Indianapolis.
Legislative clarity gives tax professionals a better sense on whether backdoor Roths will pass muster with the IRS.
“More people are familiar with it and advisors, tax preparers and CPAs will be more comfortable recommending it to clients,” said Phillips.
Here’s how to determine whether a backdoor Roth might make sense for you.
Stash money into the most efficient savings accounts first.
Individuals who opt for the backdoor Roth should already be maxing out their 401(k) contributions at work or at least getting the full employer match into their retirement plans, said Jeffrey Levine, a CPA and CEO of BluePrint Wealth Alliance in Garden City, New York.
Those workers should also stash cash in their health savings accounts, if available, he said.
In an HSA, individuals in high-deductible health plans make tax-deductible contributions to this account. There, it grows free of taxes and can be used to cover qualified medical expenses on a tax-free basis.
If you still have money to spare, consider the backdoor Roth — just proceed with caution.
“A scenario where you already have a sizable amount of money in an IRA — the backdoor Roth might not make sense there,” Levine said.
In a perfect world, a saver makes a nondeductible contribution with after-tax money and converts it free of taxes.
However, if this person already owns other IRAs with pretax amounts in them, the IRS could levy income taxes based on the overall value of all of those accounts.
The amounts you have saved in your traditional IRAs, as well as SEP and SIMPLE IRAs, would be included in this calculation.
This is known as the pro rata rule.
“What trips people up is that you can’t just create a new IRA and look at it in isolation,” said Tim Steffen, CPA and director of advanced planning at Robert W. Baird & Co. in Milwaukee.
“Let’s say you have one IRA with a lot of money in it and you create a new IRA to distribute an amount,” he said. “For tax purposes, it’s treated as if the distribution came from both IRAs, so it will be taxable.”
You can also run awry of the pro rata rule if you convert a nondeductible IRA at one point in the year and then later that same year rollover a 401(k) into a traditional IRA.
That’s because the pro rata rule considers your IRA balances at the end of the year, Steffen said.
Even if you have the money to fund a nondeductible IRA contribution, you should work with your accountant to make sure it’s right for you.
Aside from the pro rata rule, savers should also know that they or their spouse will need to have earned income in a given year in order to put money into the Roth.
“As long as you have earnings, you can make the strategy work,” said Phillips of Spectrum.