In recent years, there's been an explosion of interest in converting individual retirement accounts into Roth IRAs. The reason: a provision that unlocked this unique IRA to all taxpayers, even the very rich.
IRS rules typically allow only those people with adjusted gross incomes under $194,000 (married couples filing jointly) or $132,000 (single taxpayers) to contribute to a Roth IRA. Why? Because unlike other retirement accounts, withdrawals from a Roth in retirement are tax-free -- which is a good feature if you anticipate you'll be in a higher tax bracket later in life. As this Roth IRA calculator shows, this can add up big tax savings down the line.
After new IRS rules allowed taxpayers at all income levels to convert other accounts to a Roth, the dollar amount of conversions shot up 800% in 2010, according to a 2013 IRS report.
The change, also known as a "backdoor Roth IRA," allows even the richest Americans to take advantage of this potential tax savings. The catch: You will need to pay the taxes up front on the cash you convert into a Roth IRA.
How it works
There are essentially three steps toward executing this maneuver.
- First, put the money you want to transfer into a traditional IRA. If you already have an account, you can use that, but if you don't, you'll need to create an account through an online broker, robo-advisor or other account provider.
- Next, convert the account into a Roth IRA. Again, if you don't have an existing Roth IRA, you'll need to create a new account. Your account provider will give you all the paperwork and steps required for a Roth conversion.
- Then, Uncle Sam needs his cash. To enjoy the tax-free withdrawals in retirement, you'll need to pay taxes on the cash you're moving into a Roth IRA. If you are taking cash from an existing traditional IRA, you'll need to also pay taxes on any investment gains.
For now, converting accounts to a Roth IRA is a legal and popular way to save for retirement. But that could all change: There is a proposal before Congress that may close the loophole that created this backdoor Roth IRA.
And remember that Roth IRAs aren't for everyone -- consult with your financial advisor or tax expert before you head down this path. But if it makes sense for you, a Roth IRA can pay great dividends down the line.