Roth IRAs have some pretty big advantages over traditional IRAs. In addition to offering tax-exempt withdrawals, Roth IRAs allow savers to withdraw their contributions penalty-free at any time and have no minimum distribution requirements as you get older.
Unfortunately for high-income Americans, the ability to contribute to a Roth IRA is income-restricted. That is, if your income is too high, you aren't allowed to deposit money into a Roth IRA. However, there's a sneaky (but perfectly legal) way that you could take advantage of a Roth IRA, even if your income exceeds the limit.
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Roth IRAs have income limitations for everyone
With a traditional IRA, your ability to deduct your contributions is only limited if you or your spouse have access to a retirement plan at work. On the other hand, Roth IRA contributions are limited by income regardless of your other retirement plans.
The income limitations are adjusted annually, but for the 2018 tax year, here are the modified adjusted gross income (MAGI) limits to be able to contribute to a Roth IRA:
If your MAGI is less than the full contribution limit, you are allowed to contribute the maximum. For 2018, this is $5,500 with an additional $1,000 catch-up contribution allowed if you're 50 or older. And remember that you need to have earned income in order to contribute.
If your MAGI is in the "partial contribution" range, you can't contribute the maximum, but you can still make some contribution to a Roth IRA for 2018. The exact amount you're allowed to contribute is determined by an IRS formula that you can find on the IRS website.
And finally, if your MAGI is greater than the upper limit for your filing status, you cannot contribute to a Roth IRA for the 2018 tax year at all, even if you don't have access to a retirement plan at work.
The income limits don't apply if you convert into a Roth IRA
If you want to contribute to a Roth IRA, but your income is too high, there's a perfectly legal way around the contribution limits.
Specifically, the law says that you cannot contribute directly to a Roth IRA if your income exceeds the MAGI limit for your tax filing status. However, you can convert a traditional IRA to a Roth IRA no matter how much you make.
Here's how it works:
- You contribute to a traditional IRA for the desired tax year.
- Soon after contributing, and before you use the money to invest, you convert the account to a Roth IRA. With most brokerages, this is a simple matter of filling out a form.
- Your account will now be characterized as a Roth IRA.
- Repeat this process next year if desired, and if you still make too much to contribute directly to a Roth.
To be clear, there's no guarantee that this loophole will be around forever. However, as of 2018, Americans of all income levels can take advantage of the backdoor Roth IRA loophole.
Potential tax implications
In the interest of being thorough, it's important to mention that the second step in the list isn't entirely accurate. Specifically, you can choose to convert a traditional IRA to a Roth IRA at any time -- it doesn't have to be immediate. You can technically convert a traditional IRA you've had for decades, and some people do.
However, there's one big potential tax implication that you need to be aware of. If you've received a tax benefit from the traditional IRA, you'll have to pay income taxes when converting the account to a Roth. For example, if you contribute $5,000 to a traditional IRA this year, deduct the $5,000 contribution on your 2018 tax return, and then convert the account to a Roth, the account's value will be treated as taxable income.
To be clear, you can still make a Roth conversion in this case. Just be aware that doing so may result in a big tax bill.
It's also important to mention that if you have other traditional IRA funds, the tax implications can get a little complicated. If this is the case, be sure to listen to this excellent discussion from the Motley Fool Answers podcast before making the conversion.
A sneaky (but legal) way to take advantage of this tax-exempt retirement account
In addition to the obvious tax benefits of a Roth IRA, there are some other key advantages of investing for retirement in a Roth instead of a traditional IRA that could make using the backdoor method worthwhile. Specifically:
- Roth contributions (but not investment gains) can be withdrawn at any time, for any reason. So, a Roth IRA is a smart choice for money you don't necessarily want tied up until you're older.
- Roth IRAs have no required minimum distributions, or RMDs. Traditional IRAs require that you start withdrawing money after age 70 1/2, but Roth IRAs have no such requirement. For this reason, Roth IRAs can be valuable estate-planning tools.
- Roth IRAs have no maximum contribution age -- the only requirement is that the account owner has earned income. So, if you plan to work beyond traditional retirement age, a Roth IRA could be a smart choice.
The bottom line is that there are several reasons you may want to add a Roth IRA to your retirement strategy. And, if you decide a Roth IRA is right for you, a high income doesn't need to stand in your way.
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