Roth IRA’s are a great savings tool. Contributions aren’t deductible like with traditional IRAs, so Roth contributions don’t lower your tax bill immediately. However, the tax-free nature of any earnings, no required minimum distributions (RMD’S) and ability to withdraw your contributions at any time, tax and penalty free, make them an excellent planning and savings tool.
Before any discussion about Roth IRA strategies, it’s important to be aware of the income and contribution limitations:
In 2016, for single taxpayers, there are phase-outs between modified AGI of $117,000 and $132,000 and over $132,000 Roth contributions aren’t allowed. For married taxpayers, the phase-out range is from $184,000 to $194,000 and over $194,000 is disqualifying.
In 2016, the total amount individuals can contribute $5,500. People over 50 can contribute an additional $1,000 for a total of $6,500.
Here are some features of Roth IRA’s that highlight their unique saving and planning advantages:
1. You Can Open A Roth For Your (Employed) Children
As soon as your child has taxable earned income and regardless of age, you can contribute to a Custodial Roth IRA for them up to the amount of their earnings, or a maximum (in 2016) of $5500.00, whichever is less.
As a parent, you retain control of the account until your child turns 18 (or 21 in some states). What a great way to start a nest egg for your children and teach them something about money at the same time!
2. High Earners can contribute to a Roth 401(k)
High earners can work around the income limits noted above by contributing to a Roth 401(k) if their company plan allows it. No income limits apply to Roth 401(k) contributions so it can make good sense for big earners to contribute to a Roth 401(k) or split contributions between a traditional and Roth 401(k). Total contributions cannot exceed the 2016 limit of $18,000 or $24,000 for those 50 and older).
3. Roth Conversions
Six years ago income limits on Roth conversions lifted so that anyone no matter how much money they make can convert a traditional IRA to a Roth in any given year. High-earners may not want to take the tax hit that a conversion would trigger while earning the big bucks, but if there is a year where income is lower (i.e., a sabbatical year, quitting a salaried job to work at a start-up) a Roth conversion may be a good move.
For many, the lowest tax years of post-20’s life may be the years in between retirement and the beginning of Required Minimum Distributions (RMD’s) at age 70 ½ – this is also a good time to consider converting some IRA money to a Roth.
4. The Backdoor Roth
At about the same time the rules on Roth conversions were changed, a strategy developed called the Backdoor Roth. People who hit the income limits for Roth contributions instead contribute to a non-deductible IRA and then immediately convert it to a Roth IRA.
However, it’s not that simple because of the pro-rata rule. If the person converting has other traditional IRA assets, the taxes due on the conversion will depend on the ratio of IRA’s that have been taxed to those that haven’t. There is a workaround to the pro-rata rule: roll traditional IRA assets into a company plan such as a 401(k) or solo 401 (k) before attempting the back-door Roth, taking them out of the pro-rata equation. This move makes sense if the company plan has decent investment choices and low fees.
Due to the wide array of tax outcomes that could occur while applying these strategies, it would be wise to get a second opinion from your financial advisor or tax accountant.
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