High-Income Earner? This Trick Lets You Benefit From a Roth IRA!

By Markets Fool.com

Continue Reading Below

Source: SeniorLiving.org via Flickr.

If you think you earn too much money every year to contribute to a Roth IRA, think again. A backdoor method could allow even the highest-earning Americans to sock away money in a Roth IRA and enjoy the benefits of tax-free withdrawals later in life.

The problem
Roth IRAs are one of the best investment vehicles available to Americans looking to put money aside for their golden years. Roth IRAs, unlike traditional IRAs, don't allow investors to deduct their contributions from their current taxable income. However, what makes them popular is that they allow savers to withdraw their contributions and any gains tax-free in retirement.

That can be a big tax advantage for those of us who expect our income in retirement to push us into a higher tax bracket. But there's an obstacle for high earners: The government limits how much people can contribute to a Roth IRA if they're married filing jointly and earn more than $181,000 annually or single and earn more than $114,000. Even worse, the government prohibits married and single taxpayers from contributing to a Roth IRA altogether if their income exceeds $191,000 or $129,000, respectively.

This means that if you're one of the lucky ones who earn more than these limits, you appear to be out of luck.

Continue Reading Below

Filing Status

Modified AGI

Maximum Contribution

Married filing jointlyor qualifying widow(er)

< $181,000

up to thelimit

>$181,000 but < $191,000

a reduced amount

>$191,000

zero

Married filing separatelyand you lived with your spouse at any time during the year

< $10,000

a reduced amount

>$10,000

zero

Single,head of household, or married filing separatelyand you did not live with your spouse at any time during the year

< $114,000

up to thelimit

>$114,000 but < $129,000

a reduced amount

>$129,000

zero

Source: IRS.

The solution
In reality, however, there's a way around those IRS income restrictions. This strategy is known as a backdoor Roth IRA. Here's how it works.

While Roth IRAs have contribution limits that are based on income, traditional IRAs don't. That means anyone who is younger than 70-1/2 and has reportable income can put money in a traditional IRA, regardless of how much they earn. Granted, high-income investors won't get up-front tax deductions for their traditional IRA contributions -- those do phase-out based on income -- but that doesn't really matter, because Roth IRAs don't offer that up-front tax deduction anyway.

Regardless, you won't care that you don't qualify for the tax deduction because once you've made your after-tax contribution to your nondeductible traditional IRA, you're going to move it to a Roth IRA anyway.

The conversion
Once the investor has made their contribution to their nondeductible traditional IRA, the next step for them is to convert that nondeductible traditional IRA to a Roth IRA.

The act of converting a traditional IRA to a Roth IRA is pretty straightforward and simple. If someone has no existing traditional IRA balance and thus no mix of previously deducted and nondeductible contributions, a backdoor Roth IRA could be a no-brainer.

The only tax that will need to be paid when the nondeductible traditional IRA is converted will be on any gains that occur between the time of the nondeductible contribution and the time of the conversion to a Roth IRA. If the conversion is done within a day or two after the contribution to the nondeductible traditional IRA, or cash-like investments are held in the nondeductible IRA until the conversion is complete, then there should be little to no additional tax payment necessary because there are unlikely to be much in the way of gains to be taxed..

Converting a nondeductible traditional IRA contribution to a Roth IRA canget tricky. However, if a person already has an existing traditional IRA balance, or a mix of pre-tax contributions (contributions that were deducted from taxes when they were made) and after-tax nondeductible contributions (contributions that couldn't be deducted when they were made because, for example, income was too high), then the pro-rata rule comes into play. This rule dictates that all conversions -- even partial conversions of a traditional IRA rollover -- are proportionately applied across all your traditional IRA assets.

For example, say you have a traditional IRA worth $100,000, and 10% of it is nondeductible contributions. If you converted $10,000 to a Roth IRA, then $9,000 of the $10,000 comes out of the tax-deductible contributions, while just $1,000 comes out of the nondeductible contributions (10% of $10,000). You would have to pay taxes on the $9,000 portion that is converted to the Roth IRA.

Why do it?
If you contribute $5,500 to a nondeductible IRA each year and earn an annualized return of 6.5%, your IRA will end up being worth $475,058 in 30 years.

But remember, of that $475,058, only $165,000 is after-tax contributions to that nondeductible IRA. That means that the taxes that would be due on the nondeductible traditional IRA would be calculated on the gain of $310,058. If you're in the 28% tax bracket in retirement, that could mean that $86,816would be heading to the IRS -- assuming all the money is withdrawn -- rather than to you or your heirs.

Obviously, this backdoor solution isn't for everyone. If your situation is complicated, it makes sense to consult with your tax advisor first. But if your situation isn't complicated, this strategy could prove to be a great way to benefit from a Roth IRA regardless of your income

The article High-Income Earner? This Trick Lets You Benefit From a Roth IRA! originally appeared on Fool.com.

Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.