For those of you who have read my guide to wealth, you’ll remember that one of my points of emphasis is to save for retirement. Tax-deferred (traditional) and tax-free (Roth) 401k and IRA accounts allow us to minimize the taxes we pay in a legal manner. This allows our earnings to compound and grow faster than they would in a taxable brokerage account. Of the two, I like the Roth as it takes away all future tax headache as everything inside is tax exempt forever! It also has many advantages when drawing down (no required distributions) and as part of an estate package (automatic step up in basis).
Unfortunately, the government recognizes that the Roth IRA offers such good benefits that it has built in strict income eligibility thresholds. Singles making more than about $130,000, and married folks making more than about $190,000 can’t put anything into a Roth IRA. A Roth 401k remains a (great) option, but not all employers offer it.
For those who don’t qualify or are otherwise prohibited from contributing to a Roth IRA, we need to go in through the back door. Here are the step by step instructions:
- Open a traditional IRA
- Make a nondeductible (after-tax) contribution of $5,000 or $6,500 (depending on age), but don’t buy anything with the money yet
- Immediately convert the account into a Roth IRA
- Invest the money
Voila. Absolutely no difference in the end between this and a direct Roth IRA contribution. The back door approach exploits the loophole that tradition -> Roth IRA conversions don’t have the same income eligibility limits that Roth IRA contributions do. Now anyone without regard for income can take advantage of the great features of the Roth IRA.
Should you take advantage of this? The general rules of traditional vs Roth apply. If you plan on becoming wealthy in the future with the help of my book, you will have plenty of income-generating assets. Having as much of your wealth sheltered from tax in Roth IRAs helps to optimize your tax situation in that setting.
Keep in mind one big gotcha. If you have a large traditional IRA with a mix of deductible and nondeductible contributions, the “pro-rata” rule comes into effect. This means that you can’t just choose to convert only the nondeductible portion. If you have a $10,000 IRA with half of it as deductible (pre-tax) and the other half nondeductible (after-tax), a conversion of $5,000 will incur tax on $2,500. The best workaround is to keep the size of the IRA small and convert all of your contributions each year, or suck it up and convert the whole IRA.
Keep in mind that the pro-rata rule doesn’t apply to our 401k investments. This may be one situation where it’s advantageous to hold off on rolling over the 401k to an IRA when we change jobs.