The Secret to Getting Around Roth IRA Income Limits

On Wednesday, I gave some options for a client who was over the Roth IRA income limits but had already contributed to his account.  Despite the income limits to the Roth IRA, there’s still a way for him, and you, if you find yourself in this situation, to invest in a Roth account by sneaking in the “back door.”

In order to do this, you can make a non-deductible contribution to a traditional IRA and then covert that money right away into a Roth.  There are no income limits to converting, and you’ve already paid taxes on the non-deductible contribution, so you won’t have to pay taxes again. The best part is that you get the benefit of tax-free growth.

(Side note: If you don’t convert right away, you risk having to pay tax on any growth earned between the initial investment and the time of conversion.)  

I love this solution because:

1) You are already making a non-deductible contribution, so why not get the benefit of tax-free growth, rather than having to pay taxes on the earnings when you eventually withdraw them, and

2) It offers tax diversification for high-income earners who are likely maxing out their 401k plans at work. In other words, you can have more flexibility in retirement by being able to determine how much you take from your taxable and non-taxable accounts.

The big caveat here is to only do this if you don’t already have a lot of money in traditional IRAs.  With any conversions, all earnings and previously untaxed contributions in traditional IRAs are taxed on a pro-rata basis. In short, you can’t just pay tax on the amount converted, you have to take into account all previously untaxed contributions and earnings. You definitely want to see a tax advisor if you fall into this category to figure out what kind of tax bill you’ll face when you convert.