You Can Do a Back-Door Roth IRA

By J. Matthew Illian

NEW YORK (AdviceIQ) -- Many high earners find the front door locked when trying to fund a Roth individual retirement account directly. When the front door's locked, try the back.

This year, married couples filing taxes jointly begin to lose eligibility to contribute directly to a Roth IRA -- and reap its tax-free benefits -- when their modified adjusted gross income reaches $178,000. The phase-out range for individuals is $112,000 to $127,000. If your income makes you eligible, just open a Roth and fund it.

Steps for the back-door method take more work:

Make a nondeductible contribution to a traditional IRA. These accounts impose no income limit for contributing to a TIRA, but you do not get to deduct the contribution against your income. Even the highest-paid athlete (golf megastar Tiger Woods, according to Forbes, who last year putted his way to $78.1 million), can contribute $5,500 this year. Those 50 or older can add another $1,000, for a total of $6,500.

Convert a traditional IRA to a Roth IRA. When your TIRA contribution posts, convert the funds to a Roth IRA. Because you initially invested after-tax dollars, the conversion incurs no taxes. You now have tax-free money in your Roth IRA.

Repeat every year. Beginning at age 50, a couple can begin saving $13,000 every year and move $130,000 into a Roth IRA over the next 10 years. It will never taxed again.

If you left this $13,000 in a nonqualified taxable investment account or savings account, your interest and dividends suffer taxes every year. In the highest income tax brackets, you see rates approach or exceed 50% when including state and local taxes.

A high-income couple using this method to move $13,000 annually saves a bundle. At a 2% growth rate, tax savings top $4,861 over 10 years. An 8% growth rate produces tax savings exceeding $25,856.

One big caveat to the tax-free Roth conversion: You realize full benefits only if you own no other pretax IRAs. Any other IRA accounts, including simplified employee pension IRAs or savings investment match plan for employees IRAs, ignites taxes on a portion of your conversion. Even if your TIRA contains only nondeductible contributions, the Internal Revenue Service taxes the percentage of your pretax IRA assets to total IRA assets.

For example, Norm and Nancy are married and Norm has the only IRA account funded fully with pretax dollars. Both make $6,500 nondeductible contributions to their IRAs and immediately convert.

Norm's conversion creates $6,175 of taxable income; Nancy's conversion is tax free. Norm's tax resulted from 95% of his IRA assets ($95,000 of $100,000) are pretax. Nancy's conversion is tax free because she owns no other pretax IRA assets.

IRA rules apply on the individual level in the case of a married couple. If only Nancy makes a conversion, Norm's pretax IRA assets do not apply to the pro rata tax formula.

To avoid this pro rata rule, Norm can transfer his $95,000 pretax IRA assets into a 401(k) plan. Assets in a 401(k)s, 403(b)s, 457s or a Thrift Savings Plan avoid pro rata taxation rules. Or perhaps he converts the entire IRA in 2013, pays tax based on the pro rate formula and frees himself to make tax-free conversions beginning in 2014.

Clear out your IRAs to reap full benefits of a back-door Roth. A few extra steps make your retirement years a little more golden.

-- By J. Matthew Illian, wealth manager for Marotta Wealth Management. He is based in Richmond, Va., providing fee-only financial planning and wealth management at emarotta.com and blogging at marottaonmoney.com.

AdviceIQ is a network of financial advisors that writes insightful articles for the public about investing and wealth management. All articles are edited by AdviceIQ's editor in chief, Larry Light. AdviceIQ certifies that all its advisors have no regulatory infractions.

To subscribe to AdviceIQ's Rss feed for personal finance articles written by financial advisors and AdviceIQ editors, click here.

Follow AdviceIQ on Twitter at @adviceiq.

AdviceIQ is a network of financial advisors that writes insightful articles for the public about investing and wealth management. All articles are edited by AdviceIQ's editor in chief, Larry Light. AdviceIQ certifies that all its advisors have no regulatory infractions.

More from How-to

How to Make a Fortune Like Microsoft Billionaire Founder Bill Gates

How to Make a Fortune Like Microsoft Billionaire Founder Bill Gates

Former General Electric CEO Jack Welch Has 4 Tips to Getting a Promotion

Former General Electric CEO Jack Welch Has 4 Tips to Getting a Promotion

How Much Money Has Bill Gates Made Over Time?

How Much Money Has Bill Gates Made Over Time?

Preferred Stock & Common Stock: What's the Difference?

Preferred Stock & Common Stock: What's the Difference?

How to Buy a Stock

How to Buy a Stock