Backdoor IRA’s – The Dirty Little Secret
By this point in the year, most of us have filed our taxes and the 2016 tax year is behind us. Not many people have taxes on the mind and they will probably put off re-visiting the topic until next year, however; there is no time like the present to plan for how you can save on your future tax payments. If you are looking to pad your retirement savings, a backdoor IRA may be just the remedy for you.
What you need to know
Roth IRAs are a very popular and attractive investment vehicle for many reasons, and they are a great vehicle to facilitate a backdoor IRA. The accounts are funded with after-tax dollars, withdrawals in retirement are tax-free, and any earnings in the account are tax-deferred. Unlike the Traditional IRA, Roth IRAs are not subject to required minimum distributions during retirement, which makes them very appealing when it comes to tax planning.
Unlike with a Traditional IRA, there are income limits to opening a Roth IRA which has left many people earning high salaries believing it is not an option for them. The law states that a single person with an annual adjusted gross income of $133,000 or more, and a married couple making more than $196,000 cannot directly fund a Roth IRA. Despite this limitation, there have been no income limits placed on converting funds to a Roth IRA. This allows for strategic planning to have more tax-free money available in retirement. For high income earners, this is a fantastic planning tool.
How to do it
This work-around is called a “backdoor” approach. Most high-income earners are most likely contributing the maximum allowances to their 401k plans. This means additional contributions can be made to a non-deductible Traditional IRA. The backdoor approach would then have these investors turn around and move/convert those dollars to a Roth IRA. Because the funds are coming from another retirement account, they are not considered to be a contribution. The advantage to converting these funds is the tax-free growth that is provided in a Roth IRA. Deploying backdoor IRA’s is a little used strategy because it is widely unknown. Make sure to consult your finance and tax professionals before deploying this strategy.
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