Nearly half of all working-age families have zero retirement account savings, according to a study by Economic Policy Institute, The State of American Retirement.
There has been much discussion about eliminating the “backdoor” Roth IRA. This is a situation where the lawmakers put in place a law with unintended consequences. However, this tax loophole makes sense if it will encourage more people to save for retirement. Let me explain.
Individual Retirement Accounts (IRAs)
There are many rules regarding traditional IRAs and Roth IRAs. Both types of IRAs were developed to encourage people to save for retirement. I will briefly explain certain of the differences between these two types of IRAs and the pros and cons of each.
A traditional IRA is a personal savings plan that offers tax benefits to encourage retirement savings. In 2017, you can contribute up to $5,500 per year ($6,500 if you are 50 or older). Contributions may be fully, partially or not tax deductible at all depending on certain factors.
Your deduction may be limited if you or your spouse are covered by a retirement plan at work and your adjusted gross income exceeds $62,000 for a single taxpayer ($99,000 if married filing jointly), and you get no deduction at all if your adjusted gross income exceeds $72,000 for a single taxpayer ($119,000 if married filing jointly). However, if you are married filing jointly, and only your spouse is covered by a retirement plan at work, you will receive a full deduction up to your contribution limit, if your modified adjusted gross income does not exceed $186,000. The deduction will phase out fully when your modified adjusted gross income exceeds $196,000.
If you are not covered by a retirement plan at work (single taxpayer) or if you and your spouse are not covered by a retirement plan at work (married filing jointly) you will receive a full deduction up to the contribution limit, no matter what your adjusted gross income is.
Investment earnings in a traditional IRA grow tax deferred, but distributions will be subject to income tax.
The Roth IRA is another type of personal savings plan that offers tax benefits to encourage retirement savings. The same contribution limits that apply to traditional IRAs also apply to Roth IRAs. With a Roth IRA, however, your allowable contribution may be reduced or eliminated if your annual income exceeds certain limits.
If your modified adjusted gross income is less than $118,000 for a single taxpayer ($186,000 for married filing jointly), you can contribute up to your contribution limit. The contribution limit phases out as your modified adjusted gross income increases, and no contribution is allowed once your modified adjusted gross income reaches $133,000 for a single taxpayer ($196,000 for married filing jointly).
This contrasts with a traditional IRA where you can always contribute but do not always get a deduction (deductible versus non deductible contributions). Contributions to a Roth IRA are never tax deductible, but distributions will be income tax free as long as certain rules are complied with.
So now you know the basics of the two different kinds of IRAs.
- One type of IRA (traditional) provides an immediate tax deduction for the contribution, where as, the other type of IRA (Roth) does not.
- One type of IRA’s (traditional) future distributions are taxable, where as, the distributions from the other type (Roth) are not.
- One type of IRA (Roth) has income limits in order to contribute to the IRA where as the other type (traditional) only has income limits in order to receive the tax deduction.
Conversion of a Traditional IRA to a Roth
Prior to 2010, all taxpayers who were single or married filing jointly with an annual adjusted gross income of $100,000 or less could convert a traditional IRA to a Roth IRA. The conversion was not available to higher-income earners. Since that time, there is no income limitation on implementing a Roth conversion.
So what are some of the benefits of a Roth conversion?
- The most significant benefit is receiving tax free income in retirement. However, upon conversion you must pay the tax on any taxable earnings in your traditional IRA account and all past deductible contributions. The analysis as to whether or not to convert your traditional IRA is complicated. There are many factors to consider including future tax rates, future investment earnings and the number of years until you take your first withdrawal. In addition, whether the taxpayer has the cash outside the IRA to pay the tax has a significant impact on the analysis. If cash inside the IRA is used to pay the tax, the future benefit of tax deferrals is reduced. There are many Roth conversion templates on the internet. Here is one example.
- The Roth IRA allows contributions to be withdrawn penalty free at any time. That is unlike the traditional IRA, which imposes restrictions on early withdrawal (prior to age 59½). Traditional IRA withdrawals are included in gross income and an additional tax penalty maybe imposed, although there are certain exceptions.
- The Roth IRA allows the taxpayer who has earned income to continue to contribute to the IRA. The traditional IRA requires the taxpayer to stop making contributions at age 70 1/2.
- You generally must take required minimum distributions (RMD) from your traditional IRA when you reach age 70 1/2. However, Roth IRAs have no RMD rules. This allows the holder of the Roth IRA to leave monies growing tax free to their heirs. The distribution rules, if your spouse or another relative is the beneficiary, can be the subject of another article.
“Backdoor” Roth IRA
Remember the income limitation on a Roth conversion was eliminated in 2010. However, the income limitation was not eliminated for one’s ability to open and contribute to a Roth IRA.
To avoid the income limit on contributing to a Roth IRA, you can make a regular contributions to a traditional IRA and immediately convert to a Roth IRA. So even though you do not meet the income requirement to contribute to a Roth IRA, after the conversion you are in virtually the same situation as if you had made a contribution directly to the Roth IRA.
Since your initial contribution was non-deductible, you pay tax only on the difference between the converted value and the amount contributed, and since you held the traditional IRA for a short time the tax due upon conversion should be small. This is the case only for people who do not have any pretax money in the IRA at the time of the conversion. Conversions made when other IRA money exists are subject to pro rata calculations and may lead to a tax liability for the taxpayer.
A Tax Loophole Which Makes Sense
A tax loophole isn’t illegal. It is an ambiguity in the tax law that may result in individuals following the letter of the law, but not the spirit or intent of the law. However, if the intent of both the traditional and Roth IRAs is to have more people put away money for retirement this loophole makes sense.
Are you considering a Roth Conversion? Are you considering a “Backdoor Roth”?
TRIVIA: What does Roth in the Roth IRA stand for?
Questions or comments are encouraged!