We recommend building your retirement assets by contributing to three separate “buckets” of money: 1) traditional retirement accounts; 2) Roth accounts; and 3) taxable accounts. A previous newsletter (January 2010) discussed Roth conversions. Recent changes in the U.S. tax law have provided some new opportunities to build your Roth assets, so revisiting this topic seems warranted. This is the first of a two-part series of newsletters devoted to explaining how to take advantage of these opportunities.
Roth accounts are funded with after-tax dollars. These assets then remain tax-free while they are growing within the Roth account and upon their withdrawal. This is a potential advantage over traditional retirement plan assets, which are taxed at your marginal income tax rate when withdrawn during retirement. Roth assets have some additional advantages. Unlike traditional retirement accounts, there are no required minimum distributions on Roth accounts beginning at age 70 ½. You are free to withdraw your assets from these accounts at any age without penalty or taxation, up to the total value of your contributions. However, restrictions and penalties apply to the premature withdrawal of gains on these assets, so careful record-keeping is required.
One approach to building your Roth assets is to make annual contributions to a Roth IRA, however, there are income limits on direct contributions. If your adjusted gross income is $183,000 or less ($116,000 if single), you can deposit up to $5,500 directly into a Roth IRA each year. If you are 50 or older, an additional “catch up” contribution of $1,000 is allowed, bringing your maximum annual contribution to $6,500. If you are married, these contribution limits are doubled, since each spouse can contribute up to the maximum allowable amount.
If your income is too high to make direct Roth contributions, you can still build your Roth assets with a strategy referred to as a backdoor Roth IRA. This involves making annual contributions to a traditional IRA and then immediately converting the assets to your Roth IRA. The income limits for deductible contributions to a traditional IRA are more stringent than the income limits for direct Roth contributions, so anyone participating in the backdoor IRA strategy is doing so with after-tax dollars. With a backdoor IRA, you contribute after-tax dollars to your traditional IRA and then convert the assets to a Roth IRA. Using this strategy, a married couple can put $11,000 per year into a Roth IRA ($13,000 per year if both spouses are over age 50), regardless of income. Since your IRA contributions are with after-tax dollars that are quickly converted to Roth assets, there is generally little or no tax liability arising from the conversion.
What if you have a current IRA that was funded with pre-tax dollars? This situation commonly arises if you have rolled over a 401(k) or 403(b) account from a previous employer into a traditional IRA. These accounts are typically funded with pre-tax dollars, so if you convert these assets to a Roth IRA, they are taxed as income. Unfortunately, you cannot ignore these assets in pursuing a backdoor Roth IRA strategy. The IRS requires all your IRAs to be aggregated (i.e., treated as a single account) from a tax perspective. This is sometimes referred to as the “cream-in-the-coffee rule” because your IRA assets are considered by the IRS to be commingled, like cream in coffee. You can still contribute $5,500 per year into a traditional IRA and convert these assets to your Roth IRA, but you have to factor in your proportion of pre-tax IRA dollars for taxation purposes. One way to deal with this issue is to take the tax hit up front and convert all your traditional IRA assets to Roth assets. This will not only jump-start your accumulation of Roth assets, but also allow you to participate in annual Roth conversions without significant tax liabilities going forward.
I would be happy to answer any questions about Roth conversions via telephone or email. My associate, Jared Meese, has extensive experience in setting up backdoor Roth IRAs, so please feel free to contact him directly at jmeese@shearwatercapital.com or 314-434-4750 if you are interested in utilizing this strategy. Next quarter, we’ll discuss 401(k) and 403(b) Roth accounts and in-plan Roth rollovers.
Jeffrey J. Brown, MD CFA Principal, Shearwater Capital