We have long been proponents of the Roth IRA, as contributions grow completely tax free. Roth IRAs are an excellent tool for young earners still in a modest tax bracket, but they also have great benefits for those in the run-up to retirement. This is because they can provide a source of retirement income shielded from federal income tax, unlike typical pension and traditional IRA income. Also, withdrawals are not mandatory as they are for traditional IRAs.
So how do you get money into this valuable retirement tool?
If you have earned income, you can make annual contributions ($5,500 for those under 50 and $6,500 for those ages 50 and older in tax year 2013). There is a caveat – your MAGI, modified adjusted gross income, must be below a threshold of $112,000 for singles and $178,000 for married filing jointly in 2013. If you are just over this threshold, there is a phase-out so you can make a partial contribution. MAGI over the phase-out is the first barrier for high earners.
You can convert part or all of an existing IRA account to a Roth IRA. You will pay ordinary income tax on the converted amount, so you should not undertake this method without consulting your tax advisor. Because many nearing retirement are in higher tax brackets than they will be in retirement, this is the second barrier.
However, if your MAGI is too high for a standard Roth contribution and your current tax bracket prohibits a tax wise conversion, there is another method. Provided you have no other traditional IRA accounts to your name, you can make annual contributions to a nondeductible IRA and immediately convert it to a Roth IRA. Because there is no gain with an immediate conversion of cash, there is no tax due. This is sometimes called a back door Roth IRA and is a simple and effective conduit to provide tax free income in retirement. If both you and your spouse follow this course of action for 10 years prior to retirement, you can have $130,000 growing tax free for your retirement needs!