3 Ways to Kick-Start Your Tax-Free Retirement Savings

By Greg Ostrowski

Looking to achieve tax-free growth on retirement assets, but think because of your income level, a Roth IRA can't possibly work for you? As a self-employed or high-earning professional, there are several strategies that you should know about that may allow you to create a Roth IRA and enjoy more tax-free income in retirement.

First, let's talk basics. A Roth IRA is a type of account that allows people to save after-tax, non-deductible money for retirement. Roth IRAs are viewed favorably because they provide tax-free growth on your assets, and tax-free qualified retirement withdrawals with no required minimum distributions.

%VIRTUAL-WSSCourseInline-792%If you think that income tax rates will continue to rise, tax-free distributions would be a valuable benefit. However, under current laws, the ability to contribute directly to a Roth IRA phases out completely once your income surpasses $131,000 ($193,000 for joint filers), shutting out many high-earners who would enjoy the greatest benefits from a Roth IRA.

Fortunately, higher-earning professionals and business owners can take advantage of several perfectly legal loopholes to create backdoor Roth contributions.

Option 1: Traditional IRA to Roth IRA conversion. The simplest strategy is to contribute the annual limit to a traditional IRA and then convert those contributions to a Roth IRA. To be eligible to contribute to a traditional IRA, you must have reportable income and must be younger than 70½ at the end of the year in which you make the contribution. While some may be able to take advantage of a deduction for their traditional IRA contribution, high-income earners and participants in workplace retirement plans will probably not receive a deduction.

The IRS removed income limitations on Roth conversions in 2010. This loophole means higher income taxpayers can contribute to a traditional IRA on a non-deductible, or after-tax, basis and subsequently convert money to a Roth IRA with no tax liability.

Here's how it works:

1. Contribute the maximum amount to a traditional IRA for 2015 ($5,500 or $6,500 for those older than 50).

2. Convert the account to a Roth IRA in 2015. If you took a deduction for the contribution, you will owe taxes on the conversion. If you didn't take a deduction, your conversion is tax-free.

If you already have prior year contributions and earnings in your traditional IRA at the moment of conversion, you may owe taxes on that money, so it's wise to consult a financial professional with experience on conversions before proceeding.

Option 2: 'Serial' SEP-IRA to Roth IRA conversion. If you're a small business owner or self-employed professional, a SEP-IRA may be a good option for you. SEP-IRAs are attractive to a small business owner because you can still direct your investments, but contribute far more than the traditional IRA's annual limit. Even better, contribution limits aren't affected by participation in a 401(k) or other workplace retirement plan, assuming the SEP-IRA and 401(k) are with two separate employers not under common control.

While the SEP-IRA's sizable contribution limits can be appealing, it has the same tax disadvantages of a traditional IRA. SEP-IRA qualified retirement distributions are taxed as ordinary income when taken at age 59 or older. Fortunately, as with a traditional IRA, SEP-IRA holders can convert their accounts to a Roth IRA, albeit with a tax liability. A high-income earner could sock away additional savings by first channeling contributions through the SEP-IRA, and doing a subsequent conversion, year after year. The tax liability can be mitigated if you convert in subsequent years, which is where the "serial" part of the conversion comes in.

Here's how the strategy works:

1. Contribute the maximum amount to a SEP-IRA for 2015.

2. Receive the full tax benefit in the 2015 tax year for SEP-IRA contributions.

3. Convert the account to a Roth IRA in 2016.

4. Pay taxes on the conversion in tax year 2016.

Assuming your income levels remain the same or increase, you could repeat this process each year. All things equal, your subsequent years' Roth IRA conversion liability from the SEP-IRA is neutralized by your deductible SEP-IRA contributions for that tax year.

Option 3: After-tax 401(k) to Roth IRA rollover. In late 2014, the IRS clarified the rules regarding after-tax contributions in a 401(k); as of 2015, you can now roll these over into a Roth IRA. If your 401(k) allows after-tax contributions and allows you to withdraw these contributions each year, you might be able to take advantage of this strategy to help kick-start your Roth IRA.

Here's how it works:

1. Maximize your pre-tax 401(k) contributions (typically $18,000 in 2015 or $24,000 for workers 50 and older).

2. Make additional after-tax contributions up to the IRS maximum ($53,000 or $59,000 for workers 50 and older). Keep in mind that employer matches count toward your annual maximum.

3. Roll over the after-tax contributions and earnings into a Roth IRA. While your after-tax contributions can be rolled over tax-free, you will owe taxes on the earnings. The IRS currently allows you to choose between converting the untaxed earnings to the Roth IRA now and paying taxes on them in the same year, or rolling them over to a traditional IRA and paying taxes on the withdrawals in retirement.

Some caveats and addendums. Before you spring into action with any of these strategies, there are some important caveats that you need to understand. The first is called the "pro-rata rule," which dictates the taxation of IRA distributions (including conversions) when the IRA owner has any traditional IRA or SEP-IRA containing both pre-tax and after-tax money (workers can allocate pre-tax and after-tax amounts from 401(k) distributions to avoid this issue). One additional wrinkle is the "step transaction doctrine," which could complicate the tax consequences of a conversion that is done too soon after a contribution to the original IRA. The "serial" SEP-IRA strategy typically works best for a self-employed person with no other covered co-workers.

The bottom line. On the surface, income phase-outs and contributions limits can make it challenging for high-earning professionals and business owners to save meaningfully for retirement using a Roth IRA. Fortunately, the strategies we've covered in this article offer savvy savers an opportunity to boost the amount they save and potentially increase their tax-free income in retirement. All that being said, every individual's situation is different and details matter. To find out whether these Roth conversion strategies are right for you, talk to a qualified financial professional or a tax expert who specializes in these types of conversions.

Securities offered through SII Investments Inc., Member FINRA, SIPC. Advisory Services offered through Scarborough Capital Management, a registered investment adviser. SII and SCM are separate companies. Neither SII nor SCM provide tax or legal advice.

Opinions, estimates, forecasts and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice.

This material is for information purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security.

Investing involves risk including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss in periods of declining values. Past performance does not guarantee future results. Diversification and asset allocation do not guarantee positive results. Loss, including loss of principal may result.

Greg Ostrowski is a blogger for The Smarter Investor. Greg is a certified financial planner and managing partner of Scarborough Capital Management, offering low-cost, flat-fee 401(k) management and wealth management to individuals across America -- from millennials to retirees. You can follow him on Twitter at @gostro01 or connect on LinkedIn.