Say you want to fund a Roth IRA to take advantage of those tax-free withdrawals in retirement. But your income is too high (over $131,000 if you’re single and $193,000 if you’re married filing jointly for 2015, and over $132,000 if you’re single or $194,000 if you’re married filing jointly for 2016).
The good news: Roth IRA rules allow you to get around this restriction if you convert funds from a Traditional IRA to a Roth.
There are no income limits for converting to a Roth, and no limit on the amount you can convert. If your Traditional IRA is already at Betterment, the conversion just takes a couple clicks.
The not-so-good news: In most cases, when you convert funds from a tax-deferred account to a Roth, it’s considered a taxable event, meaning you may owe taxes on some or all of the amount converted.
How do you minimize the tax hit?
One strategy that would enable you to take advantage of a Roth, but not get hit with a super high tax bill, is to do what’s known as a backdoor Roth conversion—the how-to is detailed below—or plan ahead and take advantage of upcoming life or career changes that could nudge you into a lower tax bracket.
Here’s how to make that Roth conversion happen.
Note: Betterment is not a tax advisor, nor should any information in this article be considered tax advice. You should contact a tax professional to discuss your specific situation.
High Earners Go for Roth IRAs
If a Roth conversion sounds appealing, you’re in good company. Roth IRAs suit many high-income earners because they want a way to minimize taxes in retirement—and unlike distributions from a traditional IRA, Roth funds are withdrawn tax-free if they meet basic requirements.
Indeed, when the IRS removed the income limit on Roth conversions in 2010, the number of conversions “increased over 800%, to $64.8 billion,” according to a January 2014 IRS report. It was the first time conversions exceeded contributions. And 57% of the conversions were from people with six-figure incomes.
With the income barrier removed, the big question now is the taxes: What’s the best way to minimize the amount you have to pay when you convert?
The Backdoor Roth
The so-called backdoor Roth is one way to avoid a big tax bill when you earn more than the income limit for a Roth.
In that case, if you’re also covered by an employer retirement plan like a 401(k), you likely wouldn’t be able to fund a deductible IRA, because of IRS rules. But you could contribute to a nondeductible IRA, and then convert to a Roth.
When you contribute to a nondeductible IRA, you’re effectively depositing after-tax dollars, so you’d only owe tax on the earnings when you withdraw (or convert). If you convert to the Roth soon after, any earnings, and therefore taxes, are likely to be minimal.
This method is most beneficial tax-wise if you don’t have other deductible IRA funds. If you do, then the portion that you convert to the Roth has to be prorated over the total amount you have in all your IRAs. This is an important point that often surprises IRA converters at tax time.
As you can see in this Roth conversion example, if you have $15,000 in traditional IRAs for which you’ve received a deduction, and want to deposit $5,000 into a nondeductible IRA and convert it to a Roth, you would divide $5,000 by $20,000 (the total value of all IRAs) to get the amount you can convert tax-free, which is 25%. So you’d owe tax on the other $3,750 based on your current tax bracket.
So to review, execute a backdoor Roth conversion with these three steps:
- Minimize pre-tax IRA account balances by rolling them into your employer plan, if possible.
- Make a current year 2016 traditional IRA contribution, and don’t deduct it on your taxes (also report on Form 8606).
- Execute a Roth conversion of the contributed amount at your broker
Carpé Career Change
Another way to minimize taxes is to plan ahead, if you can, when you know that a career or life change is coming that will push you into a lower tax bracket. Then, when you convert from a traditional IRA to a Roth, the tax you’d owe would be based on that lower bracket.
Consider these major life events:
- Going to graduate school
- Making a career change that lands you in a lower-paying (but perhaps more rewarding) line of work
- A planned or unplanned period of unemployment.
- Starting your own business
In each case, you can and should continue to save in tax-deferred accounts prior to making the conversion. Then, when the life transition is underway, you can strategize about the amounts you plan to convert and when, depending on your new tax bracket.
Bear in mind that the amount you convert is considered income, so you want to make sure that amount doesn’t bump you back up to a higher tax bracket. Again, this example is only an illustration; individual specifics could change the numbers.
The greater point is that converting to a Roth may be highly desirable from a tax perspective down the road—so understand the Roth IRA rules and don’t let the tax bill today stand in your way.
We recognize that many investors are interested in this technique, so we’ve created a quick process that allows an investor to authorize a Roth conversion online in less than a minute. Betterment also supports hassle free IRA rollovers.
More from Betterment:
- IRA Calculator: Which Is Right for Your Savings Goals?
- Dip into Your Taxable Account to Max Out Your IRA
- How To Do a Direct Transfer
This article is intended for educational purposes only. The information provided is educational in nature, and is not intended to be relied upon as financial or tax advice. Investing in securities involves risks, and there is always the potential of losing money when you invest in securities.