Roth IRA’s are a great savings tool. They are different from traditional IRA’s in that they aren’t deductible, so Roth’s don’t lower your tax bill immediately.
However, the tax-free nature of any earnings, no required minimum distributions (RMD’S) and ability to withdraw your contributions at any time tax and penalty free, make them a great planning tool as well as savings tool.
Before any discussion about Roth IRA’s it’s important to be aware of the income limitations for contributions.
In 2015, for single tax-payers there are phase-outs between modified AGI of $116,000 and $131,000 and over $131,000 Roth contributions aren’t allowed. For joint tax-payers, the phase-out range is from $183,000 to $193,000 and over $193,000 is disqualifying.
Here are 3 features of Roth IRA’s that highlight the unique saving and planning advantages of the Roth:
1. You Can Open A Roth For Your (Employed) Children
As soon as your child has taxable earned income and regardless of age, you can contribute to a Custodial Roth IRA for them up to the amount they earn or a maximum (in 2015) of $5500.00, whichever is smaller.
As a parent you retain control of the account until your child turns 18 (or 21 in some states). What a great way to start a nest egg for your children and teach them something about money at the same time!
2. High Earners can contribute to a Roth 401(k)
High earners can work around the income limits noted above by contributing to a Roth 401(k) if their company plan allows it.
No income limits apply to Roth 401(k) contributions so it can make good sense for big earners to contribute to a Roth 401(k) or split contributions between traditional and Roth 401(k). Total contributions cannot exceed the annual limit of $17,500 ($23,000 for those 50 and older).
3. The Back-Door Roth and Pro-Rata Rule
Five years ago, income limits on Roth conversions lifted so that anyone no matter how much money they make can convert a traditional IRA to a Roth. At that time, a popular strategy developed called the back-door Roth.
This is how it works: people who hit the income limits for Roth contributions instead contribute to a non-deductible IRA and then immediately convert it to a Roth IRA.
However, it’s not that simple because of the pro-rata rule. If the person converting has other traditional IRA assets, the taxes due on the conversion will depend on the ratio of IRA’s that have been taxed to those that haven’t.
There is a workaround to the pro-rata rule: roll traditional IRA assets into a company plan such as a 401(k) or solo 401 (k) before attempting the back-door Roth, effectively taking them out of the pro-rata equation.
Due to the wide array of tax outcomes that could occur while applying these strategies, it would be wise to get a second opinion from your financial advisor or tax accountant.
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