Roth IRAs offer the unique ability for investors to grow their money tax-free as well as avoid required minimum distributions. Until recently, Roth IRAs were not available to “high-income” individuals. Recent tax code changes now allow such individuals to convert a traditional IRA into—but not necessarily contribute to—a Roth IRA. Some individuals who could not directly contribute to a Roth have used a “backdoor” method, first contributing to a non-deductible traditional IRA and then converting it to a Roth IRA. This effectively circumvents the Roth IRA contribution limitation.
This strategy works best for taxpayers who have no other pre-tax IRAs, either rollover or contributory. One problem clients may encounter with a “backdoor” Roth strategy is the pro rata rule, which requires clients to aggregate all their IRAs to determine the income tax owed upon conversion. If a client with no other IRAs opens a $5,000 nondeductible IRA and then converts it, the only tax owed would be on the earnings, if any. By contrast, for a client with a $95,000 traditional IRA (pre-tax contributions), who converts a $5,000 nondeductible contribution to a new IRA, the conversion would be 95% taxable.
So how do you remove a pretax IRA from the equation? Transfer it to a 401(k). Many employer plans allow “roll-ins” of IRA money to 401(k)s. How does this work? Once you move the pre-tax dollars (and earnings) into a 401(k), that leaves an IRA with no taxable income. You can then convert the after tax monies into a Roth IRA. This strategy is particularly compelling for self-employed individuals who may be able to establish their own individual 401(k)s into which they can roll over pre-tax IRA accounts.
What about a client who doesn’t have a 401(k) to transfer to, or doesn’t want to go through these steps but still wants tax advantaged income down the road? How about a Universal Life (UL) insurance policy that, assuming insurability, the client can fund at a level designed to provide a pool of money they can access in a tax favored way under current law—without waiting five years or reaching age 59 ½. Plus a client of any income level can make use of a UL. And the client gets tax advantages on the income—just like in a Roth. With the added plus of an income tax free death benefit.
By Dave Weber, CLU. Dave is the Brokerage Life Sales Director for United of Omaha.