Nothing upsets the IRS like a high-wage earner scoring a break. That’s exactly what a few adjustments to the rules governing Roth IRA contributions permit. But you have to understand the quirks to be able to take advantage of the rules and make the tax provisions work for you.
While traditional IRAs date to the 1970s, the Roth IRA is barely a millennial, born out of tax relief legislation in the 1990s. The biggest distinction with the younger sibling, of course, is that Roth IRAs are funded with after-tax dollars, offering distributions that are tax-free. That’s in contrast to traditional IRAs, which grow through pre-tax dollars, sticking you with the tax bill when distributions are made.
For 2015, taxpayers who are filing a joint return and have adjusted gross income of $193,000 or less hit the standard Roth IRA contribution limit. Single, head-of-household and married filing separately taxpayers can earn up to $116,000 to qualify for a Roth IRA.
But high-wage earners actually have one more path to a Roth: a non-working spouse is allowed to make a non-deductible IRA contribution, even with no earned income. Such a contribution would allow a tax-free conversion to a Roth each year after they contribute to an IRA. This is limited to $5,500 annually for those under age 50, and $6,500 for those over age 50.
Imagine a married, 35-year-old entrepreneur earning $500,000, whose spouse has no past IRA balances. The spouse is not allowed to make direct Roth contributions. However, you could simply open an IRA for the non-working spouse, make non-deductible IRA contributions and convert it to a Roth IRA. Make sure you file form 8606 claiming the non-deductible status of the IRA contribution. This is called a back-door Roth.
And there are other holes in the rules that actually allow Roth IRAs for higher income taxpayers who technically are excluded from contributing to them. For instance, the IRS has no income limit on IRA conversions to a Roth IRA. In other words, you can shift the deferred tax balance on a traditional IRA and make it tax-free in a Roth. To do this, you simply pay the tax from personal funds. Doing so has estate tax benefits, too, since IRAs are taxed twice for estates larger than $5.5 million for both spouses – income taxes and estate taxes are due on the same dollars.
Here’s another quirky rule: the IRS allows you to reconvert once each year. This would allow a savvy investor with larger balances to break their conversion up into multiple accounts, each with a different investment strategy. If you lose money, you could simply “de-convert” the previous higher balance and reconvert the new balance next time around. This would avoid paying conversion taxes on balances that were lost in market action.
Keep in mind, you can’t simply make after-tax IRA contributions and convert that portion without considering the totality of your IRAs. Any pretax portion must be included in each conversion, and you can do this once per year. We typically find the math works best when investors are younger and have less than $200,000 in IRAs. The more years you have until you reach 70 1/2, when you generally have to begin taking mandatory distributions from a traditional IRA, the more contributions you can make and accumulate gains tax free. This even works for retirees who have no earned income.
Remember, taxes don’t apply to earnings in a Roth IRA, and some people use Roth IRAs as an emergency fund. You can withdraw the contributions at any time. If you’re in a bind and need to take out some of the gains from your Roth IRA earnings, you should really wait until you’re at least 59 1/2 to avoid penalties.