The lure of the Roth individual retirement account is simple: You pay taxes on your contributions, and then your money grows tax-free.
Roth IRAs are particularly appealing to high earners, who may expect to be in an even higher tax bracket during retirement.
The Roth’s downside? You can’t contribute to a Roth IRA if your income is too high (more than $131,000 if you’re single or $193,000 if you’re married filing jointly for 2015).
When the Internal Revenue Service removed the income limit on Roth conversions in 2010, the value converted increased by more than 800 percent to $64.8 billion, a report from the IRS found in January 2014. It was the first time conversions exceeded contributions. And the bulk of the conversions—57 percent—was from people with six-figure incomes.
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But there’s a caveat: When you convert from a tax-deferred account to a Roth, you will owe taxes on that money.
So, how do you minimize the tax hit?
“The so-called backdoor Roth is one way to avoid a big tax bill when you’re over the income limit for a Roth.”
There are two strategies that would enable you to take advantage of a Roth without getting hit with a super-high tax bill. The first is what’s known as a backdoor Roth conversion.
The second is to plan ahead and take advantage of upcoming life or career changes that put you into a lower tax bracket temporarily.
Here’s how to get your Roth without suffering the tax consequences.
The backdoor Roth
The so-called backdoor Roth is one way to avoid a big tax bill when you’re over the income limit for a Roth.
If you’re also covered by an employer retirement plan, such as a 401(k), you wouldn’t be able to fund a deductible IRA, because of IRS rules. But you could contribute to a nondeductible IRA and then convert right away to a Roth.
When you contribute to a nondeductible IRA, you’re in effect depositing after-tax dollars, so you’d only owe tax on the earnings. If you do the Roth conversion shortly after the nondeductible contribution, the tax due to conversion will likely be nominal.
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This method is most beneficial tax-wise if you don’t have other deductible IRAs. However, there is an important caveat here: If you do have IRAs that you deducted contributions for or that you rolled out of old 401(k) plans, the taxable portion of any conversion you make is prorated across all your IRAs.
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 you 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 portion of the $5,000 you can convert tax-free, which is 25 percent, or $1,250. So you would owe tax on the other $3,750, based on your current tax bracket.
The life-event advantage
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 401(k) or traditional IRA to a Roth, the tax you’d owe would be based on that lower bracket.
- 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 under way, you can strategically convert based on your new tax bracket.
For example, if you’re planning to attend graduate school, your income could drop from the 28 percent tax bracket to the 15 percent tax bracket.
In that case, imagine that you’d like to seize the moment and convert a $100,000 IRA to a Roth. If you did the conversion while you were in the 28 percent tax bracket, you could owe about $17,250 in federal and state tax (using New York state as an example).
But if you waited until you were enrolled in school, living on a teaching stipend and squarely in the 15 percent tax bracket, you could convert the IRA to a Roth and pay $9,750—about $7,500 less.
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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.