The US Government penalizes high income earners when it comes to retirement planning. In 2015, singles earning less than $131,000 and couples earning less than $193,000 are eligible to contribute up to $5,500 or $11,000 for couples to a Roth IRA. People who earn more than these income limits only have the option of investing into a Traditional IRA. There is a way to invest into a Backdoor Roth IRA regardless of your income and it is easy to do. I’ll take you through a step-by-step process to set up a Backdoor Roth IRA. This is so easy to do it is almost laughable.
First I want to speak to why I love Roth IRAs and why I choose to setup backdoor IRAs every year until my retirement. Roth’s are a major portion of my Investment Hunting Portfolio.
Both IRA types offer tax breaks. Traditional IRA contributions are tax-deductible on both state and federal tax returns the year the contribution is made. Withdrawals however, at retirement are taxed at ordinary income tax rates. Roth IRAs do not offer tax breaks at the time of contribution. At withdrawal, all money is tax-free.
Takeaway – Traditional IRAs avoid taxes at the time of contribution. Roth IRAs, avoid taxes when taken out in retirement.
I am a firm believer in removing variables from my retirement strategy. This is why I prefer Roth IRAs. I know the tax rate I will pay today whereas in retirement I have no idea what tax rates will be. Most financial planners disagree with my philosophy. Their philosophy is that in retirement your tax rate will be lower than it is today, thus making it smarter to defer tax until retirement. I have two major issues with this logic. First, it assumes the retiree will make less money in retirement that during their working years. Second, it assumes taxes as a whole will remain constant 30 – 50 years from now. The first assumption may be correct for some, but not me. I plan on making more money in retirement than I do today. The second assumption is foolish. Tax rates will increase over-time. The US government will need more money to govern than it does today. There are some big unknowns coming in the next few decades. Social Security, Obama Care, Pension Bailouts. These will all be paid by someone, my guess, Mr. Taxpayer will pay higher taxes to cover expenses.
Backdoor Roth IRA Setup
If you earn more than $131,000 single or $193,000 couple, and want to take advantage of the Roth IRA it can be accomplished with a Backdoor Roth IRA. Below are the steps to convert a Traditional IRA to a Roth IRA.
1. Contribute up to $5,500 to a Traditional IRA
2. Contact your IRA provider and request a transfer from Traditional to Roth
3. Pay taxes on any earned income (this will be zero if you do steps 1 and 2 within a few days of each other)
You’re done. It’s that easy to take advantage of the Roth IRA regardless of your income. For more details I found a great write-up on Backdoor Roth IRAs by Joanna Pratt at nerdwallet.
What are your thoughts on IRAs? Do you contribute yearly to either a Traditional or Roth IRA? Which IRA type do your prefer? Please comment with your thoughts?