A potential downside of tax-deferred saving through a traditional retirement plan is that you’ll have to pay taxes when you make withdrawals at retirement. Roth plans, on the other hand, allow tax-free distributions; the tradeoff is that contributions to these plans don’t reduce your current-year taxable income.
Unfortunately, modified adjusted gross income (MAGI)-based phaseouts may reduce or eliminate your ability to contribute:
- For married taxpayers filing jointly, the 2015 phaseout range is $183,000–$193,000.
- For single and head-of-household taxpayers, the 2015 phaseout range is $116,000–$131,000.
You can make a partial contribution if your MAGI falls within the applicable range, but no contribution if it exceeds the top of the range.
If the income-based phaseout prevents you from making Roth IRA contributions and you don’t already have a traditional IRA, a “back door” IRA might be right for you. How does it work? You set up a traditional account and make a nondeductible contribution to it. You then wait until the transaction clears and convert the traditional account to a Roth account. The only tax due will be on any growth in the account between the time you made the contribution and the date of conversion.
If you already have an existing Traditional IRA funded by deductible contributions or a rollover from a 401K or other qualified retirement plan, this “back door” strategy could have unintended consequences. Under the Tax Code, all IRA accounts are basically treated as one account no matter how they may be divided up among different custodians and investments. If you have funds in other IRA accounts, then the rollover of your nondeductible contribution will be treated as a pro-rata distribution from all your accounts.
For example, let’s assume you have a traditional IRA with a value of $95,000 that you created by rolling over a 401K account from a previous employer. With your $5,000 nondeductible contribution, the total value of all your IRA’s is now $100,000. When you rollover the $5,000 contribution to a Roth account, the tax rules dictate that only 5% ($5,000 over $100,000) is deemed to come from your nondeductible contribution. The remaining $4,750 is deemed to come from tax deferred funds, and as such is subject to income tax.
If you would like to discuss further how a Roth IRA or a Roth IRA conversion might work for you, please contact one of the qualified tax professionals at Thompson Greenspon at 703.385.8888.