Imagine…taking income from a portfolio of real estate investments, tax-free. From a Self-Directed Roth portfolio that’s grown – tax free.
Imagine doing the same from a portfolio of stocks, bonds, annuities, mutual funds, or nearly anything else you can imagine! Now imagine your heirs stretching those withdrawals over the course of a lifetime – also tax-free. Imagine not just passing on that gift to a child but a grandchild who may outlive you by 70 years or more. That’s generations of tax-free growth in a ‘stretch Roth IRA’ And it’s a powerful concept indeed.
But some people make too much to make a Self-Directed Roth contribution. Currently, the IRS sets a maximum income threshold on contributing to a Roth IRA at 114,000 for singles or $181,000 for married couples filing joint returns for 2014 contributions. You have until April 15, 2015 to make your contribution for tax year 2014.
If you made more than this amount in 2014, though, all is not lost. You are not permanently locked out of eligibility to take the Self-Directed Roth IRA option.
Instead, you can take the “back door” into the Roth. Here’s how it works:
- Make your contribution into a traditional IRA. With your income, you’ll have to do it on a nondeductible basis. But you wouldn’t get a deduction with a Roth IRA going in directly, so it’s a wash.
- Execute a conversion.
See, in contrast to contributions of new money to Roth IRAs, the IRS sets no income limits on conversions. Congress removed the limits beginning with tax year 2010. You can execute a conversion at any income level. The IRS is happy to take your tax money this year, rather than potentially having to wait until you start taking RMDs.
Since then, the back-door Roth IRA has become extremely popular with higher income taxpayers – especially ones who can take a ‘long view’ with regard to passing on wealth to the next generation, and who are sensitive to estate tax concerns at both
Generally, doing a conversion is as easy as filling out a few forms – and paying some tax you would have paid anyway.
The potential tax savings are significant. According to research by Vanguard, “an investor who continues to contribute the maximum amount beginning at age 30 could accumulate almost $460,000 in an IRA by age 65. However, if those contributions stayed in a nondeductible traditional IRA, more than 15% would go to income taxes. By age 90, such an investor could lose more than $250,000 to taxes.”
If you took a tax deduction for your traditional IRA in prior years, and you want to roll that account over, you will have to come up with some additional taxes. Essentially, you will pay income tax for any amount you convert on which you haven’t already paid taxes. If you want the benefits of the Self-Directed Roth IRA, though, it’s likely worth the cost – particularly if you can pay the tax with money outside of the IRA.
You can pay taxes from within the converted IRA, too – but that lowers the amount of money that will be growing on a tax-advantaged basis. It still may be a good idea, but the most tax-efficient solution, long term, is to convert the full amount in the original traditional IRA, and then pay the taxes with money from outside the retirement account.
You can do the same concept with self-directed IRAs, too. The only difference is if you have assets in a self-directed IRA that are highly illiquid, it could be difficult to pay the taxes from within your IRA even if you wanted to. In these cases it’s more important to have some liquidity outside the IRA, or in other accounts, that’s available to pay the tax bill.
American IRA is a leading authority on Self-Directed IRAs and the rules that govern them. We work with independent-minded investors in all 50 states. If you have questions or would like to explore whether a self-directed IRA or conversion is right for you, call us today at 866-7500-IRA(472), or visit us online at www.americanira.com.