Also known as the backdoor IRA, Roth IRA conversions have been a popular strategy among high-income earners to make contributions to a Roth IRA. Roth IRA conversions can be a great method to maximize retirement investment, but it must be done correctly to have any value.
Roth IRA Conversions: What You Need to Know
There have been no income level restrictions for making Roth IRA conversions since 2010, hence a high income earner can do a conversion of after-tax (non-deductible) IRA funds to a Roth IRA, which is known as a ‘backdoor’ Roth IRA. In other words, the ‘backdoor’ IRA allows a high-income earner, who has exceeded the Roth IRA annual income contribution limits, to circumvent those rules and make a Roth IRA contribution.
A Roth IRA conversion allows one to convert Traditional IRA assets to a Roth IRA. People who earn over a certain amount ($133,000 single or $196,000 married for 2017) are not allowed to contribute directly to a Roth IRA. Interestingly enough, this doesn’t apply to Roth IRA backdoor conversions. One can contribute money to their Traditional IRA, and then convert the money over to a Roth IRA. In addition to the income limits, the Roth IRA contribution limit only allows for $5,500 and $6,500 if you are over the age of 50 to be contributed to a Roth IRA. With a backdoor conversion, there is no contribution limit.
Roth IRA Conversions: Things to Consider
Anyone interested in Roth IRA conversions must consider two factors:
- The step-transaction doctrine and IRA pro-rata aggregation rules. The step-transaction-doctrine is allowing time to pass between the initial contribution to your Traditional IRA and the Roth IRA conversion. It is believed that if the conversion happens too quickly, the IRS could try to void the Roth conversion.
- The pro-rata rule essentially addresses whether or not the converted contributions have either already had taxes paid on it or if there was a tax deduction already taken.
It is important to note that a Roth IRA conversion is not a way to escape taxes. Understanding how the pro-rata rule applies to your situation is very important as it can determine how much or little taxes are owed after conversions.
Roth IRA conversions continues to be a popular method for high-income earners to make contributions to a Roth IRA. If you choose to pursue conversion, make sure you factor in all of the above to make the most out of your investment.
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