Roth IRAs usually do not make it into a higher-income client’s retirement planning playbook. The income limits set in place even prevent many upper-middle-class clients from contributing to a Roth. These limits do, in fact, block clients with earnings above the annual threshold level from contributing to a Roth directly, but there is an alternative route to Roths for high-income clients looking to minimize their tax burden in retirement. Like any other detour, the path to a Roth IRA takes more time and planning, but for wealthy clients who will likely remain in the highest tax brackets even during retirement, the potential for tax-free earnings can make it worth the extra effort.
In 2014, the ability to make contributions to a Roth IRA begins to phase out for married clients with income over $181,000 ($114,000 for single clients). Roth contributions are completely blocked for married clients who earn over $191,000 and single clients who earn over $129,000.
Fortunately, these higher income clients are still allowed to contribute to a traditional IRA, although those contributions might not be tax-deductible because of the income limits that apply to deductible IRA contributions. The starting point in the strategy is to open a traditional IRA; in 2014, each client can contribute up to $5,500 to an IRA ($6,500 if the client is 50 or older).
Because the income limits that previously applied to Roth conversions have been eliminated, the client then simply converts the traditional IRA into a Roth IRA, a process that can be repeated each year in order to grow the Roth.
Of course, the client will be taxed on the Roth conversion at his ordinary income rates, but the benefit of tax-free distributions—of both contributions and earnings—during retirement outweighs this burden for many.