A Roth IRA can be a great thing if you can open one. Basically, a Roth IRA lets your money grow tax-free, and once you retire, withdrawals are tax-free as well. But to open and directly contribute the full annual limit to a Roth IRA, your annual income needs to be less than $114,000 if you're a single taxpayer or $181,000 for a married couple.
However, as with a lot of situations involving taxation, there is a way around this rule. Here's a quick guide to the "backdoor" path to the Roth and why the Roth IRA income limits don't necessarily exclude you from the Roth club. In short, the IRS allows anyone to convert a traditional IRA to a Roth IRA, regardless of income level.
Should you convert?
Depending on your current tax bracket, it may or may not make financial sense to keep your traditional IRA where it is and simply convert future contributions to a Roth account. For instance, if you're a married couple in the 35% tax bracket, your taxable income is between $398,351 and $450,000 per year. If you are expecting to be in a lower tax bracket once you retire, a traditional IRA could make more sense for your situation.
Of course, there are reasons other than taxation to want a Roth IRA. Unlike a traditional IRA, a Roth IRA allows you to withdraw your original contributions (but not your investment gains) at any time and for any reason, without having to pay an early-withdrawal penalty.
Further, traditional IRAs require you to begin taking minimum distributions by age 70-1/2. Roth accounts have no such requirement, making them an excellent choice if you don't know whether you'll even need the money in retirement and may simply let it compound for your heirs.
Start with a traditional IRA
Once you've decided it makes sense for you to pursue a Roth IRA, the first thing you should do is open a traditional IRA account with a brokerage of your choice.
While there is an income limit for making a tax-deductible contribution to a traditional IRA, anyone can make a nondeductible contribution, regardless of income level. So if you don't qualify to make a contribution to a Roth IRA, go ahead and make a contribution to a traditional account.
Then convert to a Roth
Right after your contribution posts to your account, convert your traditional IRA to a Roth IRA. The method by which this can be done differs depending on your broker, but in most cases it's as easy as opening a Roth IRA account and submitting a request to transfer your assets from one account to the other.
This sounds easy enough, and when you're dealing with a one-time contribution and transfer, it is. When converting from a traditional IRA to a Roth, you are required to pay tax on any contributions that were made on a tax-deferred basis. However, because you never claimed a tax deduction for the contribution, this doesn't apply here. Converting should be quick and painless, and as the U.S. tax law stands now, you can repeat the process every year, up to the maximum contribution of $5,500 ($6,500 if you're over 50).
If you're converting more than an immediate deposit, beware of the tax man
If you've been contributing to a traditional IRA for years, you can still take advantage of the conversion rule, but your taxes may get a bit more complicated in the year you transfer your assets. You'll be required to pay income tax on any untaxed amounts in the account you convert.
So even though your income may be too high now to qualify for a Roth IRA contribution, if any contribution to your account was originally deducted from your taxes, you'll have to pay income tax on that portion of the account upon conversion to a Roth.
The same is true for rolling over a 401(k). You're allowed to roll over assets from a 401(k) into a Roth IRA, but you'll be taxed on all of your tax-deferred contributions that were withheld from your paycheck over the years.
If you can't deduct your contributions, conversion should be a no-brainer
The main difference between a Roth IRA and a traditional IRA is when you pay your taxes. With equal tax rates, the net effect of the benefit is the same. The only difference is whether you choose to be taxed on your money now or later.
However, if you are covered by a retirement plan at work and your income is too high to allow a deduction for traditional IRA contributions, immediate conversion to a Roth IRA should be a no-brainer, especially because the Roth IRA income limits serve only to create an extra step in the process. You can either pay income tax on your original income and your investment gains, or simply pay the taxes on your current income but not on any withdrawals once you're retired. Seems like an easy decision to me.
Take advantage of this little-known tax "loophole"
Recent tax increases have affected nearly every American taxpayer. But with the right planning, you can take steps to take control of your taxes and potentially even lower your tax bill. In our brand-new special report "The IRS Is Daring You to Make This Investment Now!," you'll learn about the simple strategy to take advantage of a little-known IRS rule. Don't miss out on advice that could help you cut taxes for decades to come. Click here to learn more.
Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.