Optimize the Value of a Roth IRA Conversion
May 13, 2016
What to Look For
Many people choose to invest in a Roth IRA over a traditional IRA because of the ability to withdraw funds tax-free. Those whose joint tax return shows earnings of $193,000 or more, however, are not eligible to contribute to a Roth IRA. Still, there are possibilities to take advantage of Roth IRA benefits. It takes some strategic planning and the advice of your tax advisor.
While individuals in this higher income bracket cannot contribute to a Roth IRA through traditional means, there is a backdoor method for converting to a Roth IRA. Here’s how it works:
Make a contribution to a nondeductible IRA, which has no income limits. You wouldn’t want to keep your income in the nontraditional IRA because the accumulated income is taxed at ordinary income rates when withdrawn. So, shortly after the contribution is made (there is no time requirement) convert the non-deductible IRA to a Roth IRA. There is no income limitation on a conversion of a non-deductible IRA to a Roth IRA, so what you can’t do directly, you can accomplish indirectly. Your contribution is now in a Roth IRA, via the non-deductible IRA.
The Benefit (and Caveat)
You will not pay taxes on any portion of the withdrawal after you have converted your funds to a Roth IRA. However, there are a few traps to watch for—for example, if you convert a nondeductible IRA to a Roth, any other IRA(s) you have will be converted on a pro rata basis, and that could create ordinary income. It’s best to check with a professional before pursuing this strategy to ensure the risk of an added tax burden does not outweigh the benefits of a Roth conversion.
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