Tax-Diversify Your Portfolio Part 2: Back-Door Roths – Contribute & Convert

The uncertainty of future income tax rates makes planning for taxes more critical.   Effective IRA planning is one way to achieve tax diversification to manage this uncertainty.

As noted in Part 1 of this series, you may be limited in your ability to contribute directly to a Roth IRA. But you can use a “back door” strategy to convert non-deductible contributions to a Traditional IRA to Roth, and thus make tax-deferred savings tax-free.

Tax-Free Savings

If you are not eligible for the up-front deduction of a Traditional (deductible) IRA, you may be eligible to contribute to a Roth IRA.  Roth IRAs don’t give you an up-front deduction, but earnings are tax-free under current law.  For tax diversification, this can be a better option that the deductible IRA.  But you are only eligible to contribute if you have MAGI below certain limits:

 Roth Contribution Limits Based on MAGI

Contributions with No Income Limits

Despite these income limitations for Roth contributions, taxpayers with any level of income can contribute to a Traditional (non-deductible) IRA.  You won’t be able to deduct your contribution, but the earnings will grow tax-deferred.  And despite your level of income, you can then convert the Traditional IRA to a Roth IRA with little or no tax cost.

The Contribute-and-Convert Strategy

When you convert the Traditional IRA to a Roth IRA, you will only be taxed on any earnings.  If you made a $5,500 contribution to the Traditional IRA and it’s worth $5,510 at the time of conversion, you will only owe tax on the $10 of earnings.  Because your contribution to the IRA was made with after-tax dollars (i.e. you didn’t receive any tax deduction for the contribution), you have what is called basis in the IRA.  These dollars have already been taxed, and won’t be taxed again on conversion.

After conversion, the savings now reside in a Roth IRA, where earnings will grow tax free under current tax law.

A $5,000 contribution earning 5% annually will grow to $18,625 in 25 years.  The Traditional IRA account may have provided a $1,540 deduction at the time of the contribution, but it comes with a deferred tax bill of $5,215 on distribution, assuming a 28% marginal federal tax rate.

Beyond tax-free growth, Roth IRAs offer flexibility in pre-retirement distributions: you can always withdraw your contributions without penalty, and you are not required to take distributions from these accounts after age 70-1/2 as you are with other IRAs and 401ks (including Roth 401ks).  This flexibility make Roth IRAs excellent vehicles for savings that could be used for multiple goals (retirement, education), and make ideal assets to leave to future generations.

Don’t hesitate to consult your tax professional about your options – but note that many may not be familiar with the contribute-and-convert strategy, or may be partial to reducing all taxes today, without planning strategically for flexibility in the face of future tax rates.  Contact Satori Financial LLC to find out how we can help you determine your Roth contribution or conversion options.

If you have other IRAs, the Contribute-and-Convert strategy isn’t as tax efficient.  See Part 3: Back Door Roth Conversions-Advanced if you have any rollover, SEP or other IRAs with pre-tax savings.