Roth IRAs for High-income Families
Roth IRAs are probably one of the most powerful financial planning tools available. One of the main benefits is that it enables after-tax dollars to grow tax free and it allows distributions to be tax free at retirement. Additionally, there are ways to access the money earlier in the event someone would like to retire before the age of 59.5 (the age at which you can take tax-free/penalty-free distributions).
In the past, people who made over $169,000 (married filing joint) or $107,000 (single filer) in adjusted gross income could not even open a Roth IRA. Also, if your family income was over $100,000 you couldn’t take an existing IRA account and convert to a Roth.
However, in 2010, a new law removed the income cap for IRA to Roth conversions, meaning even Bill Gates and Warren Buffett could convert their IRAs to Roth IRAs. The conversion is a taxable event, but, if you anticipate your future tax rate to be higher – or even the same – as the current tax rate, it may make sense to do a conversion. Once the conversion is done, the money in the Roth is free of taxation forever.
In this day and age of high government deficits, it’s likely that tax rates will be higher in the future, and the anticipated tax rates through 2012 are some of the lowest this country has ever seen. So paying taxes now may make sense. Previously, a conversion done in 2010 allowed you to split the conversion taxation over two years, giving taxpayers more time to come up with the tax dollars. Generally, it’s best to pay the taxes from your own pocket, rather than from the conversion itself.
After 2011, you can still convert; however, there is no deferring the taxes over two years. That means whatever you convert in tax years after 2011; you have to pay taxes on it in the current year. Doing this could still make sense depending on your tax situation.
The conversion rule has created an interesting loophole in the tax code that even allows families with income over the limits described above to contribute to a Roth IRA. The method is a two-step process. You first contribute to a traditional IRA and record that contribution as a non-deductible one on your tax return. (For most people over the income threshold, they are unable to make deductible IRA contributions anyhow because they are contributing to a 401k plan, etc.)
Once the non-deductible IRA contribution is made, you can convert that to a Roth. The conversion is allowed since there’s no income restriction for conversions. This allows a family to put money into a ROTH without meeting the income requirement.
Because the contribution to the IRA was non-deductible (after tax dollars), the conversion may be 100% tax free. What determines if the conversion is tax free is what other types of retirement accounts the taxpayer has. If the taxpayer doesn’t have any money in an IRA, SEP or a SIMPLE IRA, the conversion is tax free. If the taxpayer does have money in an IRA, SEP or a SIMPLE IRA, a part of the conversion may be taxable. It’s best to seek advice from your CPA, or from your Redwood wealth manager on the taxation strategy around the conversions.
For now, this loophole is available, and for higher-income families, it may be the only way to contribute to an account that permanently grows tax free, and keep it away from the government!