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Roth IRA Rules: Smart Ways to Avoid Taxes on a Conversion

roth ira rules.jpgYou want to open a Roth IRA to take advantage of those tax-free withdrawals in retirement. But your income is too high (over $129,000 if you’re single or $191,000 if you’re married filing jointly for 2014).

Good news: Roth IRA rules allow you to get around this restriction if you rollover funds from a 401k or traditional IRA to a Roth. There are no income limits for rolling over to a Roth, and no limit on the amount you can roll over. And Betterment is engineered to make any IRA or 401k rollover as seamless as possible.

Not-so-good news: In most cases, when you rollover funds from a tax-deferred account to a Roth, it’s considered a Roth conversion, and you will owe taxes on that money. 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 (details 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 rollover happen.

High earners go for Roth IRAs

If a Roth conversion sounds appealing, you’re in good company. Roths are appealing to 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because they want a way to minimize taxes in retirement—and unlike distributions from a traditional IRA, Roth funds are withdrawn tax-free.

Indeed, when the IRS removed the income limit on Roth conversions in 2010, the number “increased over 800%, to $64.8 billion,” a new report from the IRS found in January. It was the first time conversions exceeded contributions. And the bulk of the conversions (57%) was 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’re over the income limit for a Roth.

In that case, if you’re also covered by an employer retirement plan like a 401k, 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 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 within a few days, the tax will likely be nominal.

This method is most beneficial, tax-wise, if you don’t have other, deductible IRAs. 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.

As you can see in 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.

Carpe 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 401k or traditional IRA to a Roth, the tax you’d owe would be based on that lower bracket.

For example:

-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.
For example, if you’re planning to attend graduate school, your income could drop from the 28% tax bracket to the 15% 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% tax bracket, you could owe about $17,250 in federal and state tax (in New York, for example).

But if you waited until you were enrolled in school, living on a teaching stipend and squarely in the 15% tax bracket, you could convert the IRA to a Roth and pay $9,750—about $7,500 less.

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.

Betterment is not a tax advisor, nor should any information in this article be considered tax advice. If you need tax advice, please consult a tax professional.

Interested in learning more about Betterment? Betterment is the most preferred automated investing service, designed to optimize your returns, save you time and money, and minimize your taxes. Visit Betterment.com for more information.

Determination of most preferred online financial advisor reflects Betterment LLC’s distinction of having the most customers in the industry, made in reliance on customer counts, self-reported pursuant to SEC rules, across all online-only registered investment advisors.

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