The Roth IRA has been a great retirement savings tool for some people over the years, mostly thanks to the potential tax benefits that come with Roth IRA withdrawals. Unlike a traditional IRA, where money can be deposited on a pre-tax basis, leaving the earnings to accumulate on a tax-deferred basis, the Roth IRA contributions are made on a POST-tax basis. From there, the earnings in a Roth can grow tax-deferred, and distributions will be tax free, as long as certain conditions are met. Not bad.
The problem, though, is that not everyone qualifies to be able to contribute to a Roth IRA. For 2017, the ability to make a Roth contribution starts phasing out for single individuals with an Adjusted Gross Income above $118,000, and for married couples (filing jointly) whose AGI is more than $186,000.
But all is not lost for those over the income limits who want to get money into a Roth IRA. It can be done with a strategy known as a “back door Roth,” or the “Roth Two-Step.” Here’s how it works: You first make a non-deductible contribution to a traditional IRA. This is Step One. Remember, even if you can’t deduct the contribution, anyone with earned income can contribute to an IRA, regardless of how high their income is.
So once you make the non-deductible contribution, you move to step 2 – you simply convert that traditional IRA into a Roth IRA. That’s it. No taxes are paid on the conversion. The money is placed under the Roth IRA umbrella and can then grow in the Roth from there on out, as long as you continue to follow the rules for the Roth IRA.
One caveat here: If you have other IRAs with deductible contributions or earnings, this muddies the water a little bit. When you mix pre-tax with post-tax monies in your IRAs, any conversions you make will be done on a pro-rata basis – meaning part of the conversion will be taxable to you. The Roth 2-Step works best when you have ONLY non-deductible money across all of your IRAs.
But even if you do have pre-tax money in your IRA, you might be able to move that portion to an employer plan, like your 401(k), leaving only your post-tax money in your IRA. From there, you could still make the tax-free conversion.
Keep in mind, the Roth Two-Step strategy has to be done correctly, or you could wind up paying big taxes and penalties. So be sure to check with your adviser to see if it makes sense for you. This is what we do every day with our clients, so just give us a call – we’re here to help!