Roth IRAs—with their promise of tax-free growth and withdrawals—are appealing retirement savings vehicles. However, income restrictions typically limit the ability of high-income earners to contribute to these accounts. Fortunately, there are strategies for getting around these restrictions, including using "backdoor" Roth IRAs.

Right for You?

The primary difference between traditional and Roth IRAs is the timing of income taxes. Traditional IRA contributions are potentially deductible—which means that they are funded with pre-tax dollars—but the withdrawals of contributions and earnings are taxable. In contrast, Roth IRA contributions are non-deductible—which means they are funded with post-tax dollars—but withdrawals of contributions and earnings are tax-free. Withdrawals from either type of IRA before age 59½ are generally subject to a 10% penalty. The penalty also applies to withdrawals from Roth IRAs that are less than five years old.

For most savers, the decision between a traditional and a Roth IRA depends on whether or not they are better off paying taxes now or later. If you think your tax rate will decrease in retirement, deferring taxes in a traditional IRA will result in a lower overall tax liability. However, if you expect a higher tax rate in retirement, a Roth IRA may produce greater post-tax returns.

Furthermore, with a traditional IRA you must take required minimum distributions (RMDs) beginning at age 70½, but with a Roth IRA you can leave the funds in as long as you want. If desired, you can let the funds grow tax-free for life and then pass them on to your beneficiaries tax-free. On the other hand, if your beneficiaries inherit a traditional IRA, they will be stuck with a substantial income tax bill as the account is distributed to them.

Income Limits

Traditional and Roth IRAs are subject to the same contribution limits, which are currently $5,500 per year or $6,500 if you are over 50 years old. Anyone with sufficient earned income can contribute the maximum amount to a traditional IRA, although deductions for those contributions may be reduced or eliminated depending on your income and whether or not you are eligible for a qualified retirement plan at work.

Furthermore, contributions to a Roth IRA are phased out for high income earners. For individuals, the maximum 2017 contribution is reduced when modified adjusted gross income exceeds $118,000 and eliminated when it reaches $133,000. For joint filers, the thresholds are $186,000 and $196,000, respectively.

Through the Backdoor

Income phaseouts do not necessarily need to deter you. One option is to participate in a 401(k) or other qualified retirement plan that permits Roth IRA contributions. Generally, these contributions are not subject to income limits.

Another possibility is the "backdoor" Roth IRA. Each year, you contribute the maximum amount to a nondeductible traditional IRA and then convert it to a Roth IRA. There are no income restrictions on Roth IRA conversions. You will owe taxes on the traditional IRA's earnings, but you can minimize those taxes by completing the conversion quickly.

However, it is important to understand the pro-rata rule before choosing a backdoor Roth IRA. If you have other IRAs that hold pre-tax contributions and earnings, the taxable portion of your conversion is calculated by aggregating all of your IRAs and multiplying the converted amount by the ratio of pre-tax to post-tax assets. However, there may be a way around the pro-rata rule. If you are self-employed with a solo 401(k) or if your employer has a retirement plan that permits roll-ins, you may be able to transfer your pre-tax IRA assets into that plan.

Rules are Complex

The rules regarding Roth IRA conversions are complex. Your advisor can help you navigate them to avoid unpleasant tax surprises and achieve your retirement savings goals.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.