SUMMARY
- Roth IRA contributions are made after paying taxes but enjoy tax free compounding.
- Direct contributions to a Roth IRA are not possible at high income levels- but there are indirect methods to contribute to a Roth IRA for high earners.
- A careful analysis of income, taxes, cash flow, non-cash compensation, risk management and individual objectives are important to devise a strategy to access these indirect methods to access a Roth IRA.
A Roth IRA is a powerful way to compound money without having to pay any taxes in the future. Most people think that a Roth IRA is not accessible at high income levels. However, as we will see in this article, there are ways to take advantage of a Roth IRA even at high income levels.
Before going into the details let’s get into the basics of a Roth IRA. Unlike a traditional IRA or a 401 (k) account where you contribute with pretax income, in a Roth IRA you contribute with after tax income. So, while it does not reduce your current income tax, the contributions grow tax free and withdrawals are not taxed if you hold the account for at least 5 years (5-year rule) and you are older than 59 ½ years. (There are exceptions to this rule as discussed in IRS Publication 590-B.) Your contributions can however, always be withdrawn tax free.
Apart from the tax advantage discussed above, a Roth IRA has other benefits: You don’t have to take mandatory withdrawals after the age of 70 ½ (which is the case with the traditional IRA and sometimes with the 401 (K) account because of the Required Minimum Distribution or RMD). In fact, you can continue to make contributions at any age as long as you have earned income.
The total amount that you can contribute to both the traditional IRA and the Roth IRA is $5,500 in 2018 ($6500 if you are 50 years or older). While there are no income limits for contributing to an IRA (The tax deductibility of an IRA depends on your income if you also have a workplace retirement plan), contribution to a Roth IRA are limited based on income. If your modified adjusted gross income (MAGI) is less than $120,000 ($189,000 if married filing jointly) you can contribute up to the maximum limit. The amount you can contribute is lesser with higher MAGI and falls to zero at $135,000 ($199,000 if married filing jointly).
So how can someone with a MAGI above that amount take advantage of a Roth IRA? There are several ‘backdoor’ ways to access a Roth IRA.
Through Roth conversion: You can convert your traditional IRA to a Roth IRA. This will entail paying income tax on the amount of conversion. You are better off paying the tax from funds outside your IRA (If not, your withdrawals to pay the tax will be taxed and you will incur a 10% early withdrawal penalty). This strategy is best carried out when you are temporarily in a low tax bracket perhaps because you are between jobs, or if you expect to be in a higher tax bracket in the future- as is the case sometimes with retirees who may have the RMD from their IRA after the age of 70 ½ . This is also a strategy that can be pursued when you are hit with the Alternative Minimum Tax (AMT) such as when you exercise Incentive Stock Options- in this case you can convert your traditional IRA to a Roth IRA up to the point that your income tax equals the AMT so that you don’t have to pay any more taxes than the AMT. This strategy requires a careful analysis of all your sources of income some of which can be under your control. One thing to note with the Roth conversion is that the above mentioned 5-year rule applies each time you convert.
Through Roth 401K contributions: Some 401 (K) plans allow participants to contribute to a designated Roth account within the plan. The total contribution to both before tax 401 (k) and the Roth 401 (k) account, cannot exceed the elective deferral limit of $18,500 in 2018 ($24,500 if you are 50 years or above). Contributing to a Roth 401 (K) only makes sense if you are in a low tax bracket or if you expect to be in a higher tax bracket in the future. Like the Roth IRA, contributions to a Roth 401 (K) are made with after tax dollars, so you don’t avoid current taxes, but your money compounds tax free. However, unlike the Roth IRA which does not have any RMD requirement, you are required to take the RMD from a Roth 401 (K) when you turn 70 ½ or when you retire whichever is later. To avoid this, you can convert your Roth 401 (K) to a Roth IRA account, which then follows the rules pertaining to the Roth IRA.
Through after-tax contributions to a 401 (K) plan: If your plan allows it and if your cash flows justifies it, you can contribute to a 401 (k) over and above your elective deferral limit of $18,500 ($24,500 over the age of 50). The total amount of contributions (Your and your employer’s) cannot exceed $55,000 In 2018. You will be contributing after paying income tax, so you will not be avoiding current income tax. However, when you separate from your employer, retire or if your plan allows in-service distributions, you can convert the after-tax contributions to a Roth IRA which then compounds tax free forever. Any earnings from the contribution will be taxed but can be converted to a traditional IRA along with the pretax contributions.
You can pursue a similar strategy by contributing to a nondeductible IRA (Irrespective of the level of your income) and then converting that to a Roth IRA. The IRS will pro rate the before tax and after-tax monies across all your IRA accounts to calculate the taxable amount. If you have IRA accounts with pretax contributions, then your benefit from this strategy may be limited.
The decision to take advantage of the above strategies depends a lot on your specific situation especially as it pertains to your income (MAGI). To some extent, you can manage your MAGI- for example, delay exercising non-qualified stock options, which would trigger ordinary income if exercised or harvest capital losses to reduce income. To maximize the advantage of the above strategies a thorough analysis of your situation is important. Income and taxes are not the only consideration- your cash flows, risk management of your portfolio, views on your company stock price and your objectives play an important role as well.