Invest in Roth IRAs with Caution

Jane Young, CFP, EA

Jane Young, CFP, EA

A Roth IRA can be an excellent vehicle to save for retirement but it’s not without limitations.  With a Roth IRA you invest after-tax dollars that grow tax free and can be withdrawn tax free in retirement. This can be beneficial unless you are currently in a high tax bracket and anticipate being in a lower tax bracket in retirement.

Income limitations can be a significant downfall with Roth IRAs.  During your highest income years you may be ineligible to invest in a Roth IRA and there can be substantial penalties for making ineligible contributions.  In 2015 the income limit for someone filing single begins at $116,000 and the income limit for someone filing married filing jointly begins at $183,000.  If you make a contribution and your income exceeds the limitations, you have until your tax deadline, including extensions to withdraw your contribution.  It’s easy to inadvertently make ineligible contributions and there aren’t many red flags to alert you to the problem.  If you don’t withdraw excess contributions within the deadline you will incur a 6% penalty for every year the money remains in your Roth IRA.

Also be careful not to exceed the annual Roth IRA contribution limits.  In 2015 the contribution limit for investors under 50 is $5,500, if you are over 50 you can make an additional catch-up contribution of $1,000. Also keep in mind that Roth IRA contributions can only be made with earned income.

If your earnings exceed the income limitations and you still want to participate in a Roth IRA, you may have several options.   Your employer may offer a Roth 401k in addition to a traditional 401k.   With a Roth 401k, your employee contributions can go into the Roth option but the employer match must go into a traditional 401k.  A second option is to convert a traditional IRA to a Roth IRA but the amount converted is taxed as regular income in the year of conversion. As a refresher, with a traditional IRA and 401k you invest with before tax dollars and you pay regular income tax on the full amount when you withdraw the money.  Finally, you can consider investing in a non-deductible IRA and immediately convert it to a Roth IRA, also known as a backdoor Roth IRA.

Initially, the backdoor Roth sounds like the perfect solution because there is no income limitation on a non-deductible IRA and it’s funded with after tax dollars. Theoretically, immediate conversion to a Roth IRA should be tax free. The hitch comes from the IRS rule requiring you to aggregate all of your IRAs and proportionately include money from all IRAs in your Roth conversion.  Traditional and rollover IRAs are comprised of pre-tax dollars so the proportion of the conversion coming from these IRAs will be taxed as regular income.  Although backdoor Roth IRAs can be complex but they can be a good option if you don’t own other IRAs.