Roth IRAs are among the most powerful retirement savings vehicles. Fortunately, there are more ways to create them than people realize.
You’re probably familiar with the two most common ways to create a Roth IRA. The most common way is to convert a traditional IRA to a Roth IRA. We’ve discussed conversions in detail in the past, most recently in the May 2018 issue. Of course, you have to include the converted amount in gross income and pay income taxes on it. Some people don’t want to pay the taxes that are due on a conversion.
The other common way is simply to make a contribution to a Roth IRA. The contribution limit for 2018 is $5,500 ($6,500 if you’re older than 50). This option isn’t available to everyone. Contributions to roth iras aren’t allowed for singles with adjusted gross incomes exceeding $135,000 and married couples filing jointly with adjusted gross incomes (AGIs) exceeding $199,000.
You don’t have to give up on having a Roth IRA if neither of those strategies works for you. There are other routes to obtaining a Roth IRA
After-tax 401(k) money. This is a strategy we’ve discussed in the past and that not enough people consider
Most 401(k) plans allow you to contribute after-tax money in addition to the annual tax-favored contribution. The tax-favored contribution is limited to $18,500 in 2018. But you’re allowed to contribute additional amounts, up to a total of $55,000 in 2018. The additional contributions are included in gross income, so you receive no tax benefit from the contribution.
But when you leave the employer, these after-tax amounts can be rolled over into a Roth IRA. You roll over the rest of the 401(k) to a traditional IRA and roll over the after-tax contributions directly to a Roth IRA. You ultimately can create a Roth IRA this way regardless of how high your income is, because there’s no income limit on the after-tax contributions to a 401(k).
The beneficiary rollover. The same strategy works for beneficiaries of a 401(k) or other retirement account. Suppose someone was making after-tax contributions to a 401(k) but passed away before rolling over the account to IRAs.
The beneficiary can roll over the account to IRAs. The after-tax contributions can be rolled over directly to a Roth IRA and be treated as an inherited Roth IRA. The rest of the account is rolled over to a traditional IRA and treated as an inherited traditional IRA.
Roth 401(k)s. Employers have been allowed to offer Roth versions of 401(k) s for a few years, and more and more of them are offering the option. Employees can choose between contributing to a traditional 401(k) account or a Roth 401(k) account. The same contribution limits apply to the two types of accounts. If your employer allows you to split contributions between the two types of accounts, the aggregate contribution limit is the same as if you contributed to only one account.
Again, the income limits that apply to Roth IRA contributions don’t apply to Roth 401(k) contributions. No matter how high your income, you can defer some of your salary into a Roth 401(k). After leaving the employer, you can roll the account balance directly to a Roth IRA.
The pre-tax IRA rollover. Most rollovers send the money from an employer retirement plan such as a 401(k) to an IRA. But rollovers also can go in the other direction. When you’re still working, you can roll over money from an IRA to the employer’s 401(k) plan, if the employer’s plan allows it.
That can present an opportunity.
Suppose you have both pre-tax and after-tax dollars in your IRA. This would happen when you made nondeductible contributions to the IRA. You can roll over only the pretax dollars to the employer plan. That leaves only after-tax dollars in the IRA. The after-tax dollars eventually can be rolled over from the employer plan to a Roth IRA with no taxes due.
The solo 401(k). Self-employed individuals can create their own retirement plans. One plan for self-employed people without employees is the solo 401(k), which can be either a traditional plan or a Roth version.
Because these are 401(k) plans, there is no income limit to participating in the Roth version. You can contribute the maximum 401(k) amount each year. The contribution will be included in your gross income when you have the Roth version. But it’s treated like any other Roth money once it is in the account. Income and gains compound tax free, and the money is tax free when distributed to you. Or you can roll it over to a Roth IRA in the future.
The back door Roth IRA. This is another strategy we’ve discussed in the past. It is appropriate for someone whose income exceeds the limit for making annual Roth IRA contributions.
In this strategy, first you make a nondeductible contribution to a traditional IRA. Then, you convert the traditional IRA to a Roth IRA. There will be little or no tax on the conversion, because there won’t be much accumulated income in the IRA.
There’s a limit to the strategy. If you already have one or more traditional IRAs that have pre-tax money in them, then part of your conversion will be taxable. When you convert the nondeductible contributions, all your IRAs are aggregated and you are treated as converting a pro rata portion of pre-tax and after-tax money.
Example. You have traditional IRAs with a total of $100,000 in them. Your records show $10,000 in pre-tax money (nondeductible contributions). The rest is after-tax money in the form of deductible contributions and accumulated earnings. If you want to contribute $6,500 this year as a nondeductible contribution and convert it to a Roth IRA, then about 6.10% of the converted amount will be tax-free ($6,500/$106,500). The rest will be included in gross income.
Some tax advisors used to say the IRS could challenge the back door Roth IRA if you did the conversion very soon after making the contribution. But in the Tax Cuts and Jobs Act, Congress tried to make clear that the back door Roth IRA is a valid strategy.
Excess 401(k) contributions. Some employers allow employees to make contributions that exceed the annual contribution limits. These contributions, of course, aren’t excluded from gross income. But the employers put them in tax-free accounts and the money then can be converted into a Roth account in the retirement plan. Check to see if your employer allows excess contributions and how the plan treats them.
The bottom line is that if you want the benefits of a Roth IRA, there’s probably at least one way you can create one.