From 401(k)s to Roth IRAs, the government provides several savings vehicles for retirement.
But if you're a high earner, it's difficult to maximize your retirement savings using a Roth IRA because the IRS sets contribution limits according to income.
However, if you want to take advantage of the tax-free growth and distributions a Roth IRA offers, there's a way to do it. It's called a Roth conversion, often referred to as a "backdoor Roth IRA."
Thanks to a federal loophole that removed the income limit for Roth conversions in 2010, many high-income earners can capitalize on a backdoor Roth IRA, which allows you to convert a traditional IRA into a Roth IRA and bypass the income limits the IRS sets. The simplest way to execute a backdoor strategy is to open a non-deductible traditional IRA and then convert the account to a Roth IRA.
A backdoor Roth IRA is an effective way to maximize retirement income along with other savings strategies, but there are both advantages and drawbacks.
Here are some things to keep in mind:
There are tax implications
Since a Roth is funded with after-tax dollars, the money grows tax-free and withdrawals are tax-free as long as the money has been in the account for at least five years and you are over age 59 and a half. Withdrawals before this age also are tax-free if you only take out the amount you've contributed and not the earnings.
Eric Meermann, a certified financial planner, enrolled agent and portfolio manager with Palisades Hudson Financial Group in Scarsdale, N.Y., says that high-income earners should take advantage of a backdoor IRA because it reduces the government's cut of your investment gains over time.
You can convert both a non-deductible traditional IRA and a traditional IRA into a Roth. However, if you convert a traditional IRA, you must pay taxes on these contributions at the time of conversion since these assets have not yet been taxed. This is because the pro-rata rule makes conversion tricky. This rule makes it difficult to execute a backdoor strategy if you already have a traditional IRA. The rule causes all individual IRAs -- both non-deductible and deductible -- to be treated as one account for tax purposes. You then pay taxes on the deductible portion that will be converted into a Roth IRA.
"This could necessitate some creative planning, such as rolling funds into a 401(k) or other employer retirement plan," Meermann says about a traditional IRA conversion.
"[But] If you expect to face a higher tax rate in the future, converting to a Roth is still more beneficial, even if you end up paying some tax at the time of conversion, since you'll be paying at the lower rate," he says.
Meermann suggests using funds from other sources to cover these taxes. If you use money from your IRA account balance, you could face early withdrawal penalties.
Backdoor IRAs may not last forever
The loophole that created backdoor Roth IRAs in 2010 could change.
President Obama proposed getting rid of the loophole in his 2016 budget, but Congress chose to keep the provision that removed income limits for Roth conversions.
The backdoor Roth IRA doesn't have a set expiration date -- yet. Take advantage of this while it lasts to boost your retirement savings.
"Backdoor Roth IRAs also tend to work best serially; a one-time conversion is likely to be relatively insignificant in an affluent saver's overall strategy," Meermann says. "This means that really taking advantage of this opportunity will require regular action on the saver's part."