Posted on August 18, 2014 · Posted in orange county financial planner, Uncategorized

Roth IRA Contribution Loophole:

Often our high income clients express the great frustration of the lack of retirement options for high income earners. It’s true Congress & the IRS have disallowed deductions for contributions to most plans for high income earners. What is often more frustrating is what Congress & the IRS have defined as “high income”. For 2014 the limit for Roth IRA’s is $181,000 of AGI for a married couple filing jointly if they would like to contribute the maximum $5,500 (Note if you are 50+ in age the limit is $6,500). These are not big numbers and they exclude the benefit of a Roth IRA from so many of our clients who are successful entrepreneurs and business owners.

The benefit of a Roth IRA are tremendous. The taxpayer does not receive a deduction when contributing but is also NOT TAXED when withdrawing from the account down the road during retirement. The investments in the Roth IRA also accrue tax free. This is a huge benefit to the taxpayer as we have no idea what tax rates will look like in the future. With ever increasing levels of debt and impending inflation as Congress will inevitably need to “monetize the debt” by printing money we have to assume rates will go higher. If you thought in your lower earning retirement years your tax rate would be lower you should consider Congress’ bad spending habit. Having funds invested in a Roth circumvents the need to worry about increases in tax rates because the funds coming out of a Roth are not taxable. Jarus Wealth Advisors has tasked itself with assisting clients in moving as much into a Roth IRA as possible because of this HUGE benefit.

Now for the Good Part!  The Roth IRA Contribution Loophole:
We must first travel back to 2010 when Congress decided to implement income limits on contributions to Roth IRA’s but not on conversions. This created a unique tax and retirement planning opportunity for our clients. As CPA’s here at Jarus Wealth Advisors we have been able to capitalize on the ability to transfer funds in through what has come to be known as “back door Roth IRA contributions”. There is a hitch which is that you will be required to pay tax on any amount rolled over to a Roth IRA account from a pre-tax account like a 401k. Often it proves to be a good investment to pay the tax now and not later on the total appreciated value of the account.

The Roth IRA loophole for those who do not have an existing account to roll over:
For our clients who do not already have a pre-tax retirement account we have a unique solutions which has worked well for many of our clients and which is completely legitimate in the eyes of the IRS. In this scenario Jarus Wealth Advisors sets the client up with a non-deductible Traditional IRA account at Charles Schwab (our custodian). The 2014 limits are the same as 2013 mentioned above and stand at $5,500 per person or $6,500 if 50+ years old. We then file IRS form 8606 to properly report the non-deductible contribution to the IRS with the client’s tax return. It’s imperative that Jarus Wealth Advisors track the basis of our clients deductible vs. non-deductible contributions in all accounts to ensure proper treatment in retirement years when funds are withdrawn.

After we have established and funded the non-deductible traditional IRA account with Schwab we initiate a rollover to a Roth IRA for the client. Our CPA advisors then must perform a calculation to comply with the IRS’s pro-rata rule for rollovers. The IRS requires that we consider all the client’s outstanding Traditional IRA accounts and present the basis of contributions made in both deductible and non-deductible fashion. If the taxpayer had only made non-deductible contributions there will be no tax. However most clients have at some point made tax-deductible contributions in earlier years when they had lower levels of earnings, often when they were starting businesses. In the presence of tax-deductible contributions we must consider what percentage were such and then apply that percentage to the current year Roth IRA rollover deeming that portion to be taxable as income in the year of the conversion.

This backdoor comes with a catch of course. No free lunch. According to the IRS, rollovers are a taxable event so in a conversion the combined balance of all Traditional IRA accounts must be factored. This is known as the pro-rata rule. If you have other existing Traditional IRA accounts that include both deductible and non-deductible contributions, the rollover will be taxed based on the prorated amounts of each. Huh?!

If you are a self-employed business owner and an existing client of Jarus Wealth Advisors we have likely setup a SEP IRA for your business. The SEP allows us to maximize the usage of the Roth IRA loophole because the contribution limits are much higher than traditional IRA’s. Our clients who are self-employed operating as sole proprietors or S Corp owners have a $52,000 contribution limit for 2014! (Click to see 2014 SEP Contribution Limits). The entire amount of the SEP contribution can be rolled into a Roth IRA and although it results in the client paying tax for what would have been a deductible SEP contributions the client receives the benefit of investing a large amount in a Roth each year (at least for now until this valuable tax strategy is closed by Congress).

The CPA’s of Jarus Wealth Advisors work with clients to project maximum tax savings and tax free returns when performing conversions to Roth IRA’s. We can estimate the taxpayer’s return in years for contributions comparing the tax paid to convert to the projected tax savings. We typically find that if the client has 7+ years it’s safe to say this strategy will be accretive to the total return in after tax dollars realized in retirement.

If you are interested you can visit the Charles Schwab website and use their Roth IRA conversion calculator by clicking here: Schwab’s Roth IRA conversion calculator

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