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Roth IRAs are very attractive retirement investment and estate planning tools. They offer you:
- Tax-deferred compounding.
- Tax-free qualified withdrawals.
- Freedom from required distributions within your lifetime.
- Income tax-free withdrawals for your heirs.
The big problem, though, is that until recently, Roth IRAs weren't generally available to people with income above the contribution limits. That changed a bit in 2010, with a new law removing the income limits on conversions from traditional IRAs to Roth IRAs. That opened up a strategy commonly known as the back-door Roth.
How does that work?
To get a back-door Roth, you simply:
- Convert your non-deductible traditional IRA to a Roth IRA using your IRA custodian's forms.
- Fill out IRS Form 8606 along with your other tax paperwork at tax time.
As easy as that sounds, this is taxes we're talking about, so there are catches. As with any IRA, you have to have sufficient taxable compensation to fund your initial contribution. If you're younger than 59 1/2, there's a five-year window after you convert before you can withdraw the money without worrying about possible penalties. And as with any traditional-to-Roth IRA conversion, you need to consider whether you'll owe taxes on any of the amount you convert.
In addition, be very careful about this: When you convert from a traditional IRA to a Roth IRA, the IRS considers all of your traditional IRAs as one account when determining the tax treatment, not just the nondeductible IRA you're converting. Because of that tax treatment, if you have other pre-existing traditional IRAs, you may owe tax on some of the conversion amount, as well as the income tax on your initial contribution.
All that said, once you've completed your back-door Roth IRA conversion, your account can give you a retirement of tax-free withdrawals that the Roth IRA was designed to provide.
Why would you do this?
When all is said and done, the prospect of the Roth IRA's tax-free withdrawals in retirement provides a powerful pull for people to go through the effort of getting their money into one.
Imagine the possibility of a lifetime of tax-free income provided by high-yielding mortgage REITs such as Chimera (NYSE: CIM ) and Capstead Mortgage (NYSE: CMO ) . Of course, their leverage and dependency on favorable interest-rate environments mean that their income will always be volatile. Still, as long as they don't entirely crash and burn, their status as REITs mean they're required to pay large dividends so long as they have the earnings to support them.
Or for the more risk-averse investors, imagine owning iShares Barclays TIPS Bond (NYSE: TIP ) and getting the benefits of its inflation-protected income, tax-free. Especially given the way taxes are levied on unrealized gains on TIPS in ordinary accounts, TIPS investors can really benefit from the tax-free nature of Roth IRAs.
And even investors in ordinary bonds, such as Vanguard Total Bond Market Fund (NYSE: BND ) , can benefit from the tax treatment that Roth IRAs provide. After all, if the typical bond investor loses 2 percentage points to taxes every year, holding those bonds in an IRA will keep those friction costs away.
Why wouldn't you?
Of course, not all investments are suitable for owning in an IRA. Limited partnerships such as Enterprise Products Partners (NYSE: EPD ) and Atlas Pipeline Partners (NYSE: APL ) can create something called unrelated business taxable income, or UBTI. If an IRA receives $1,000 of it in a year, the IRA will owe income tax on that UBTI. That's not exactly the end of the world, but it does somewhat defeat the purpose of having an IRA in the first place.
On the flip side, municipal bonds often offer tax-free income without needing to be held in an IRA. As a result, most of the benefits of IRAs aren't all that beneficial for municipal-bond investments such as iShares National Municipal Bond (NYSE: MUB ) . Since IRA contributions are limited, it's generally a good idea to save that limited room in your portfolio for investments that can genuinely benefit from being there.
If it's right, now's the time
If your income is too high to directly contribute to a Roth IRA, and if you don't already have a large traditional IRA, then now's your chance to get in through the back door. The long-term benefits of a Roth IRA can now be yours.