In my previous article on Simplifying saving for college, I talked about getting your money into Roth IRA since its one of the most flexible tax advantaged retirement vehicles. However, IRS has an income limit restriction. They will not let you contribute if your Modified Adjusted Gross Income (MAGI), married filing jointly, is greater than $196,000 (2017 number).
Then, how do we do it? We take advantage of a tax loophole where conversions from other Retirement accounts to Roth IRA is possible.
Let me tell you step-by-step as to how I do it. I use Vanguard heavily since the cost structure of Vanguard is pretty solid and they have extremely low expense ratio for most of their funds (I can get into more details of Vanguard in a different post). The trick is that I don’t have a Traditional IRA with loads of money in it. This is the bedrock of conversion methodology. This is because when you convert from one Retirement Account to another one like Roth IRA, it leads to a taxable event. If you have plenty of pretax money lying around in a Traditional IRA and if you convert it to Roth, it will lead to a big tax bill that year (Even if you contributed to Traditional IRA with post tax dollars, the growth/earnings portion will trigger a tax bill). Below are the right steps to achieve the most optimal results if you don’t have money lying around in an existing Traditional IRA.
- Open a Traditional IRA with Vanguard if you don’t have one.
- Contribute $5500 (the contribution limit in 2017). Buy whatever fund you desire.
- Open a Roth IRA with Vanguard if you don’t have one yet.
- Once the funds have settled into the Traditional IRA (takes a couple of days or so), ask Vanguard to convert the funds to Roth.
- The important point is to do it ASAP after the funds are available to be converted because you don’t want the money to grow before it reaches Roth; otherwise you will have to pay taxes on the growth.
This technique is called “The Backdoor Roth”. I don’t know how long this loophole will last, hence make hay while the sun shines.
Of course, the best advice here is for people whose MAGI (married filing jointly) <$196,000, please open a Roth IRA right away and start contributing directly to Roth instead of using the Backdoor hack. IRS starts phasing out the benefits beyond the MAGI (married filing jointly) of $186000; hence you won’t get to contribute the full $5500 between $186,000 and $196,000. If your MAGI (married filing jointly) lands below $186,000, you get the full $5500 to contribute.
Eventually, I will write another post where I will tell you another trick about contributing to Roth. Meanwhile, keep reading and start saving!