Time to catch up? l Insightful Investing

By Jeffrey Moormeier | Aug 14, 2019

What if I could show you a way that you could open a Roth retirement account, regardless of your income level? The Roth account was introduced in 1997, by Sen. William Roth of Delaware.

The Roth account has a distinct tax benefit. Distributions from a Roth come out tax-free.  And they may be passed on to the next generation. The disadvantage is that not everybody is qualified to contribute to one. Depending on your tax filing, marital, and income status, you may or may not contribute.  In 2010 the law changed to allow anyone to convert an IRA into a Roth account.  Therefore some affluent people who can not contribute to a Roth, may convert an IRA to a Roth.

Here are the steps:

1)    Open a traditional IRA if you don't already have one set up.

2)    Make the maximum IRA contribution. For 2019 the maximum is $6,000 if you are age 49 or younger and $7,000 if you are 50 or older.

3)    Convert the funds to a Roth, which is allowed since the income limit restrictions changed in 2010.

4)    Play by the rules. Taxes might be owed on the conversion if the original contribution was with pre-taxed dollars. If you have after-tax dollars in the conversion, the pro-rata rule will apply. Future contributions to this account will not be allowed if your income exceeds the IRS allowed limits. Make sure to get good tax advice.

5)    Wash, rinse, and repeat. Do this every year.

This strategy can be found in tax expert Ed Slott's booklet, “Retirement Decision Guide, 2019 edition,” on page 40. He also makes a statement about how Congress and the IRS have given this strategy the green light. It is called the "backdoor Roth strategy."

In every case, Roth assets grow tax-free. There is another significant wrinkle to Roth accounts. There is no Required Minimum Distribution or RMD. In other words, the Roth account may be passed from generation to generation while maintaining the tax-free income status of the distributions. There are some age restrictions. There may be estate taxes, but no income taxes.

This backdoor strategy is based on the idea that everyone can contribute to an IRA account. The caveat is that the contribution may not be deductible.  And that is the point of the Roth account. All contributions to Roths are not deductible, and there are limits as to who can open a Roth in the first place. The back door strategy requires you to open a new IRA and make a conversion every year.  In my opinion, that is a small price to pay for an account that will never be taxed again.

Let me say this one more time: A person who does not qualify, because they make too much money, can have a tax-free Roth account that can be passed down to the next generation, income tax-free. And the tax structure of this account will not change, no matter who owns it.

So let's say that you go through the hassle of applying this strategy. The first year you end up with a $5,000 to $6,000 Roth account. And you think, this is no big deal. You say, "it is not worth the bother." You stick with the program and do this same thing for 10 to 20 years. Now you have $50,000 to $120,000 of contributions in a tax-free account. It is essential to add here that there is no age limit on making contributions. You can make these contributions until you, well drop dead. At that point, the beneficiary is not required to take any distributions and continues this same practice. And so on.  At some point, the owner may start withdrawing money. And the distribution phase must adhere to some rules as well.

Any contributions may be taken out at any time without taxes or penalties. Penalties and taxes may apply to the earnings in certain circumstances. If you are under the age of 59.5 and the account is less than five years old, earnings would be taxed and penalized, except in certain circumstances like a first time home purchase (up to a $ 10,000-lifetime maximum), pending death or disability, qualified education expenses, etc.  Make sure to check with a qualified expert before making a distribution.  If you are over the age of 59.5 and the account is less than five years old, the earnings will be subject to taxes but not penalized.

The long-term benefits of tax-free investing far outweigh the hassle of knowing the rules and how to take advantage of them. Can you imagine what it would be like to build an account over multiple generations that is income tax-free?

And what if you got a little lucky and bought an investment inside of it that grew like, Apple, Amazon or Microsoft?  There would be an estate tax problem, but not an income tax problem.

We will leave that discussion for another day.


Jeffrey Moormeier of JG Moormeier Financial is a Mukilteo-based financial advisor affiliated with KMS Financial Services, Inc. an SEC registered investment adviser. His column does not represent the opinions of KMS, nor is it an official prediction or recommendation of any kind. The opinions expressed in this column are generalizations. For advise catered to your specific financial circumstances, contact Jeff directly at jeff@jgmoormeier.com or 425-931-8898.

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