The Roth IRA may be one of the best retirement invention to come along since the original IRA in 1974. Although you don’t get the immediate tax deduction like you can with the traditional IRA, you do get tax free growth potential. And over time that can be a really big deal. At a hypothetical 7.2% average annual compounded rate of return your money will double about once every 10 years. For younger investors saving for retirement this can amount to huge tax savings. Lets say you’re 40 years old and begin Roth IRA contributions of $5,000 per year for 25 years until you turn 65. Earning 7.2% per year would leave you with an account balance of $325,473. Maybe the best part of this is that the earnings are 100% tax free! You put in $125,000 of your own money, which means you saved from having to pay taxes on over $200,000 in growth.1
Ok. Thats great. But what if I make too much money to contribute?
As you may already know the Roth IRA has some income restrictions. In 2015, if you are single and make over $116,000 or are married filing a joint tax return and make over $183,000 your ability to contribute to a Roth IRA directly will begin to be phased out. Over $131,000 if your single or over $193,000 for those filing a married filing joint return, you will not be eligible to make a direct contribution to a Roth IRA at all.
So what can you do?
The way around the Roth IRA income limits, is to first make a nondeductible contribution to a traditional IRA, then immediately convert that IRA to a Roth. The elimination of the $100,000 modified adjusted gross income limitation in 2010, is what really paved the way for this “loop hole” strategy. Because the Traditional IRA was funded with after tax dollars, the only taxes you might have to pay would be on any gains that occurred in the account before the conversion. If you convert immediately this shouldn’t amount to much.2
Very Important. Understanding the IRS pro-rata rules.
The strategy I outlined above works great as long as you don’t already have any other traditional IRA accounts funded with pre-tax dollars. This also includes any 401k’s or other employer sponsored retirement plans you may have rolled over into an IRA. If you have existing IRA’s the IRS requires you to use a pro-rata formula for calculating the tax on your Roth conversion.
Here’s how it works:
Lets say you have a $45,000 IRA account that was rolled over from a 401k plan at your last employer, and you want to use the “loop hole strategy to fund your Roth IRA because you are over the income limit. If you want to contribute $5,000 to your Roth IRA you would first need $5,000 in traditional IRA contributions. Regardless of whether or not you contribute the $5,000 into your existing IRA, the one with $45,000 already in it, or you contribute it to a brand new one, the IRS considers it all one IRA for purposes of the pro-rata rules. Now, according to the IRS you have $50,000 in IRA money, $45,000 of it has not been taxed yet and $5,000 has already been taxed. Or, stated differently 90% is taxable, and 10% is non taxable. So when you do the conversion, the IRS considers your $5,000 Roth conversion to be 10% non-taxable and 90% taxable.
1. The loop hole strategy can be a great way make Roth IRA contributions if you are over the income limit, however be careful of getting hit by taxes caused by the pro-rata rule.
2. If you are over the income limit and want to use the “loop hole” strategy consider converting your existing IRA’s to a Roth. You will definitely want to run this by a tax or financial professional to make sure it makes sense in light of the taxes and future growth potential of the account.
3. Before you rollover a 401k or other retirement plan into an IRA, think about how that might limit your ability to use the “loop hole” Strategy. (This is one of the very few circumstances I sometimes advise against a rollover.3
1.This is a hypothetical example and is not representative of any specific situation. Your results will vary. The hypothetical rates of return used do not reflect the deduction of fees and charges inherent to investing.
2. Traditional IRA account owners should consider the tax ramifications, age and income restrictions in regards to executing a conversion from a Traditional IRA to a Roth IRA since the converted amount is generally subject to income taxation
3. The Roth IRA offers tax deferral on any earnings in the account. Withdrawals from the account may be tax free, as long as they are considered qualified. Limitations and restrictions may apply. Withdrawals prior to age 59 ½ may result in a 10% IRS penalty tax. Future tax laws can change at any time and may impact the benefits of Roth IRAs. Their tax treatment may change. Prior to conducting a rollover, investors should carefully consider all choices available including various factors such as investment options, services offered, withdrawal rules, required minimum distributions, legal aspects, and any employer stock.