Tax Free Investing!

Over the years, Roth IRAs have become a desirable retirement planning tool. Roth IRAs are one of the most tax-efficient ways to build wealth for those who can qualify.  There is a gotcha to the Roth IRA investment strategy. To be able to qualify you have to earn under a certain amount of income.

Below are the 2021 MAGI (Modified Adjusted Gross Income) income limits by filing type

• Single – MAGI less than $140,000 where eligible contribution begins to be reduced at $125,000
• Married filing jointly – MAGI less than $208,000 where eligible contributions are reduced to $198,000
• Married filing separately – MAGI less than $10,000

Based on these income limits, the moment you regularly earn enough to fully fund your Roth IRA, you find yourself earning too much to qualify to contribute to a Roth IRA. This can be frustrating for high-income earners who wish to use this tax-efficient account to grow their wealth.

There is still hope. If you are fortunate enough to earn an income that puts your MAGI over these limits there is another way to get those savings into a Roth IRA. It is called a Backdoor Roth Conversion. Some consider it a tax loophole because it is an exception to the rule high-income earners can use to take advantage of the tax code.

The steps to opening a Back Door Roth IRA Conversion are below.

1. Open a traditional IRA and a Roth IRA at your favorite discount brokerage firm (Vanguard, Fidelity, or Schwab).
2. Contribute a nondeductible contribution to your Traditional IRA.
3. Convert these contributions into the Roth IRA you opened by doing something that is called a Roth Conversion. You can do this by reaching out to your financial advisor or your discount brokerage firm.  
4. Ensure when you do your taxes that you complete Form 8606.

What to be Concerned About

Be careful because if you already have a Traditional IRA or an IRA rollover and have taken a tax deduction you could trigger ordinary income taxes. Form 8606 and a tax professional can help you through what you may owe in taxes. They can also advise you if it is worth doing a Roth Conversion, given your current income.

Another concern is that you can’t withdraw money in a Roth IRA for five years if you perform a ROTH conversion. If you withdraw these funds, you could incur a penalty. If you are not planning on investing for the long term and think you need the money within the next five years, I recommend using a different investment strategy.

Lastly, and probably most importantly, is the net aggregation rule. To summarize, the net aggregation rule states, if you have other IRA accounts (Traditional or rolled over IRA accounts from a previous 401k) that qualified for a tax deduction, you have to fill out form 8606 to determine how much of your backdoor Roth will be added to your Adjusted Gross Income (AGI). Even if your backdoor Roth raises your income, it may still be worth doing to get the tax-free growth down the line.

If you have more questions about doing a Roth Conversion, please use the contact information below and set up a meeting to talk to someone at our firm.