The main difference between the two types of IRAs is how and when your money is taxed. Here are several features that make the Roth IRA a better choice for those who qualify.
Discovering the Magic of a Backdoor Roth Conversion
Roth IRAs are growing in popularity for a reason – they are a very attractive savings vehicle. An increasing number of people are discovering how the unique properties of a Roth IRA can not only help them secure their financial future, but also help fund other key financial goals, such as buying a house or funding a child’s college education. Unfortunately, not everyone is eligible to contribute to a Roth IRA due to income limitations. That’s where a “backdoor” Roth IRA conversion comes in, making this dynamic savings vehicle available to almost everyone. In this article, we explain how, but first we look at what makes the Roth IRA so attractive?
What’s So Special about a Roth IRA?
The Roth IRA is the younger cousin of the more widely used traditional IRA. However, whereas the traditional IRA allows for a tax-deductible contribution and the tax-deferred growth of your earnings, contributions to a Roth IRA are not tax-deductible, but the earnings grow tax-free. That means, when you withdraw your money from a Roth, you pay no income taxes, while withdrawals from a traditional IRA are taxed as ordinary income.
The real magic of a Roth IRA is with its tax-free withdrawals. As with a traditional IRA, you can begin to take penalty-free withdrawals at age 59 ½. You can take tax-free withdrawals as long as you’ve held your Roth account for five years. You are also allowed to withdraw your own contributions at any time (after five years) tax-free and without penalty. There’s definitely magic in that.
While some may argue that the current tax deduction for a traditional IRA contribution can be more valuable than future tax-free withdrawals of a Roth IRA, they should probably take a closer look. A Roth’s tax-free income in retirement can actually lower your overall taxes in several different ways, not only increasing your cash flow, but also extending your retirement capital further into the future. Here’s how:
Above all, a Roth IRA is your insurance against likely tax increases in the future. You may feel as though your tax bracket may be lower when you retire (which could justify taking current tax deductions on a traditional IRA); however, in the current political environment, chances are tax rates are heading higher. With a Roth IRA, that wouldn’t matter.
The contribution limits for a Roth are the same as a traditional IRA – up to $6,000 in 2019 or $7,000 if you are 50 or older. However, if your income exceeds $122,000 ($193,000 for joint filers) in 2019 you may only make partial contributions and no contributions are allowed for incomes over $137,000 ($203,000 for joint filers).
However, if your income exceeds the limits, you can always gain entrance to the Roth through the “backdoor.”
How Does the Backdoor Roth IRA Work?
Incredibly, the tax code includes a “loophole” that allows individuals who otherwise don’t qualify for a Roth IRA to fund a traditional IRA and then convert it into a Roth. There is no income limit and there is no limit on how much or how many times you convert.
The only hitch is that, when you do convert, it triggers a tax on the conversion amount because it is treated as a distribution from your traditional IRA. For example, if you contribute $6,000 to a traditional IRA and then transfer it to a Roth, that amount is added to your adjusted gross income (AGI) and taxed at your federal tax rate. The key is to convert just enough to avoid pushing your AGI into a higher tax bracket.
You can also convert existing assets from a traditional IRA without limitations. If you have $100,000 in a traditional IRA it can all be converted at once. However, keeping in mind the tax implications, it may be better to convert portions of it over several years.
For Roth Conversions, There May be No Time Like the Present
Thanks to the Tax Cuts and Jobs Act, your current federal tax rate may be the lowest you’ll see in your lifetime, which is why converting to a Roth now might make sense. And, knowing our politicians’ appetite for finding new sources of revenue, the backdoor Roth “loophole” may someday be a target.
However, as straightforward as a Roth conversion may appear, it is fraught with potential hazards if the rules are not followed to the letter. You still have time to consider a Roth conversion this year, but it would be important to plan your strategy with the help of a qualified tax advisor.
Read other situation analysis articles