Stiff-Arm the Taxman with a Backdoor Roth IRA

The origins of the Roth IRA go back to Newt Gingrich’s takeover of Congress back in 1994 and the “Contract with America,” where it was called the American Dream Savings (ADS) Account.

Unfortunately the plan was vetoed and never set into motion. However, two years later the Taxpayer Relief Act of 1997 was passed and allowed people to contribute to a Roth IRA plan for the first time ever in the year 1998. The new plan allowed workers to contribute after-tax dollars and have it grow tax deferred until they’re eligible to withdraw the money tax free.

The plan also came with two more benefits. Anyone who contributes to an IRA can roll it over to a Roth IRA, and the plan uses the current year’s income to determine eligibility of contribution or rollover.

However, many individuals were prevented from participating in the Roth IRA because of the stringent qualification requirements. The legislation decreed “highly-compensated” workers couldn’t contribute to Roth IRAs.

Was this Bill Clinton’s way of claiming a possible tax break for the middle class from this Republican legislation? That’s another article…

Anyway, let’s fast-forward to the present. Highly compensated earners still can’t make annual contributions to Roth IRAs – directly. However, 2010 gave them a loophole…

Two years ago, Congress allowed for the expiration of the $100,000 adjustable gross income (AGI) limit on Roth IRA conversions. This ended income limits on Roth conversions while leaving income limits on contributions in place. In effect, this change enabled anyone (regardless of income) to convert and/or contribute to a Roth IRA.

Why Should I Care Now?

Here are few reasons why converting to a Roth may be good for you:

1. Roth contributions are made with after-tax money, but the earnings and all withdrawals in retirement are tax-free. So, a Roth provides a big tax break on the back end that a traditional IRA does not.
2. Roth withdrawals aren’t included in determining how much of a retiree’s Social Security check is taxed under current law. Nor is how much in extra income-based Medicare premiums he/she has to pay.
3. You must start taking minimum required distributions from a traditional IRA when you turn 70 and a half, but you don’t have to take any withdrawals from a Roth IRA.
4. Further, you can leave the whole account to your offspring, who can then stretch out tax-free withdrawals over their own projected life spans.
5. It especially makes sense for people who are younger, because they have more years of tax-free growth.

A Few Concerns Before Jumping In…

You may have heard that a Roth conversion usually means paying a big tax bill. Pulling all of those pre-tax and tax-deferred earnings out could mean a pretty substantial immediate hit.

If you want to limit any conversion tax hit, first roll the pre-tax dollars in your IRA (including pre-tax contributions and tax-deferred earnings) into your employer’s 401(k) plan.

Once that’s done, your IRA will hold only your after tax IRA contributions and possibly earnings on them, depending on whether your 401(k) will take such earnings. Make new after-tax contributions for 2011 and 2012, and then convert at little or no-tax cost.

You probably want to check with your employer sponsored plan about this, but the majority do allow for the roll-in of IRA money. With tax rates and reform on the legislative table, this may be an option to seriously consider.

Good Investing,

Jason Jenkins

Article by Investment U