Tax engineers: Dennis and Anne Frailey in their Fairview, Tex. home with years of spreadsheets and... [+] financial records.
This story appears in the Feb. 27, 2012 issue of Forbes magazine, p. 56, titled “Roths For The Rich.”
As soon as Congress created the Roth individual retirement account in 1997, Dennis Frailey wanted one. He saw immediately how a Roth, which allows money to grow and be withdrawn tax free, could help him manage his tax bill in retirement. “In my alternative life I should have been a financial planner,’’ says Frailey, a 67-year-old Ph.D. software engineer who since 1980 has used his own spreadsheets to track his spending, investments and taxes and to project his retirement income.
Just one hitch: Congress decreed highly paid workers couldn’t contribute to Roth IRAs, and Frailey always earned too much from his job at Raytheon in Plano, Tex. to qualify. (Now retired from the corporate world, he teaches part time at Southern Methodist University.)
Fifteen years later high earners still can’t make annual contributions to Roth IRAs–directly. But today they can shovel as much as $12,000 in 2011 and 2012 contributions per person into Roth IRAs by dancing a little two-step through the Roth’s back door.
First, they must contribute aftertax money to a traditional IRA. Then they can move that money into a Roth through a “conversion.” This works because Congress, in its wisdom, ended income limits on Roth conversions as of 2010 while leaving income limits on contributions in place. Frailey himself did a backdoor Roth in 2010, the first year it was allowed (and his last year at Raytheon). His wife, Anne, 60, a software engineer for the federal government, is now making backdoor Roth contributions. “It really pays off for people to learn about these things,’’ he says.
Wait a minute. Doesn’t a Roth conversion usually mean paying a big tax bill? Not if you first execute yet another, even more arcane maneuver—namely, rolling any pretax contributions and earnings sitting in your traditional IRAs into a 401(k) plan.
Is all this shuffling of money to snag a tax benefit legit? The lawyers and CPAs we interviewed insist it is. To be safe we also asked the Internal Revenue Service. A spokesman said the tax agency knows about backdoor Roths and doesn’t object, so long as they’re “done correctly” and reported on your 1040. Here’s what you need to know.
Why you want a Roth IRA. There are three types of retirement account contributions—before tax, traditional aftertax and Roth. Money you put into an IRA or 401(k) before it’s been subjected to income tax grows tax deferred, but all withdrawals in retirement are taxed as ordinary income at a current top rate of 35%. Traditional aftertax contributions also grow tax deferred, and when you make withdrawals all earnings (although not your original aftertax contribution) are taxed. Roth contributions are made with aftertax money, too, but the earnings in a Roth and all withdrawals in retirement are tax free. So a Roth provides a big tax break on the back end that a traditional aftertax IRA doesn’t.
Moreover, under current law Roth withdrawals aren’t counted for the purposes of determining how much of a retiree’s Social Security check is taxed or how much in extra income-based Medicare premiums he has to pay. These extra premiums can come to thousands a year and are likely to grow.
Roths have yet another distinct advantage for affluent families. You must start taking minimum annual distributions from a traditional IRA when you turn 70.5, but you don’t have to take any withdrawals from a Roth. Instead, you can leave the whole account to your kids (or better yet, grandkids) who can then stretch out tax-free withdrawals over their own projected life spans.
Front-door contributions. To the extent you or your spouse have earned income, you can contribute $5,000 per person a year ($6,000 if you’re 50 or older) to either a deductible, nondeductible or Roth IRA. You have until Apr. 17 to make contributions for calendar year 2011. So in theory a 50-plus couple could make total contributions of $24,000 for 2011 and 2012 right now.
The catch is, if you’re offered any sort of pension or retirement savings plan at work the deductible or Roth IRA contributions you’re allowed are limited as your income rises. For 2011 the deductible contributions allowed to a couple begin to shrink when their adjusted gross income climbs above $90,000 and disappear once their AGI hits $110,000. Roth eligibility starts phasing out at $169,000 and disappears at $179,000. For a single, 2011 eligibility for deductible IRA contributions ends at $66,000 and for Roth at $122,000. But anyone under the age of 70.5 with earned income, even Mitt Romney, can contribute to a traditional aftertax IRA.
Note that if you’re offered a Roth 401(k) at work, there are no income limits. But any dollars you contribute to a Roth 401(k) reduce the pretax contributions you are allowed to make to a 401(k)—and you may not want to sacrifice that current tax deduction.
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View galleryRoth conversions, classic. In a classic conversion you transfer money out of a traditional IRA, pay the taxes due (preferably out of non-IRA cash) and move your stash into a Roth, where all further growth is tax free. The catch is, you must convert a pro rata share of all your traditional IRA dollars, including previously untaxed contributions and earnings. So, for example, if you have a traditional IRA with $95,000 of pretax money and you make a $5,000 nondeductible contribution to that IRA, 95% of any dollars you convert to a Roth now are taxable.
Well-paid workers—particularly those in their 40s, 50s and 60s—often have substantial pretax money sitting in IRAs, either because when they switched jobs, they rolled a pretax 401(k) balance into an IRA or because they made deductible contributions before Congress slapped on income limits or before they earned too much.
The 401(k) roll-in play. The pro rata Roth IRA conversion rule only applies to IRA assets, not money in a 401(k) or similar workplace plan, such as a 457 or 403(b). If you want to limit any conversion tax hit, first roll the pretax dollars in your IRA (including pretax contributions and tax-deferred earnings) into your workplace 401(k), advises Barry Picker, a CPA and IRA expert in Brooklyn, N.Y. Make sure the transfer is done directly from one financial firm to another.
Once the transfer is complete your IRA will hold only your aftertax IRA contributions and possibly earnings on them, depending on whether your 401(k) will take such earnings. Make new aftertax contributions for 2011 and 2012, and then convert at little or no tax cost. If Congress doesn’t change the co*ckamamie law, you can make new aftertax annual contributions, and do additional conversions, in 2013 and in later years, too.
Never heard of a roll-in? Most plans don’t advertise that it can be done. Yet according to the Plan Sponsor Council of America, 63% of all 401(k) plans do allow it. Fidelity Investments reports 99% of the plans it administers allow roll-ins, and Charles Schwab & Co. says 80% of its plans do.
Most of these employers accept roll-ins of both pretax IRA dollars you built up from annual contributions and money rolled into your IRA from a previous 401(k) or similar plan. So, for example, Anne Frailey was able to roll a fat pretax IRA that was itself a rollover from a prior employer’s 401(k) into her federal Thrift Savings Plan. That has allowed her to fund a backdoor Roth IRA without paying any conversion tax.
Use common sense. Don’t roll your IRA stash into your workplace 401(k) if its fees are high or investment choices lousy. Consider, too, that the funds in an IRA can be easier to get at in a pinch. For example, you can take money out of a traditional IRA but not a 401(k) to pay college bills. (You’ll owe ordinary income taxes but not an early withdrawal penalty on IRA college withdrawals.)
If your 401(k) at work is a bad deal or doesn’t allow roll-ins, and if you have self-employment income, you can set up a one-person 401(k) for your side business and roll your pretax IRA money into it, suggests Ben Norquist, president of Convergent Retirement Plan Solutions. Be careful where you set up this 401(k). Fidelity and TD Ameritrade allow roll-ins to individual 401(k)s; Schwab and Vanguard don’t.
Keeping the IRS happy. For each tax year that you make a nondeductible contribution to an IRA you must file a Form 8606 (Nondeductible IRAs) with your 1040. Any contribution you make for 2011 gets reported on an 8606 for 2011—even if you make it in 2012.
By contrast, any 401(k) roll-in or Roth conversion you do in 2012 isn’t reported until you file your 1040 for 2012. At that point you’ll need to include as “IRA distributions” the amount you rolled into your 401(k), as well as the amount you converted to a Roth. Don’t panic. If you’ve done this right you’ll be able to write a tiny number or “0” as the taxable share of those distributions. A hassle? Yep, but worth it, we think, to get money into a Roth.
