Getting Money Into a Roth IRA if Your Income is Too High
You see a lot of talk on personal finance websites about the benefits of contributing to a Roth IRA. It’s a topic I’ve written on the last couple of weeks as well.
But what happens if you can’t contribute to a Roth IRA because you make too much money (>$137,000 income for a single tax filer, >$203,000 for a married tax filer)? Are you out of luck?
The answer is no, you’re not out of luck. There’s a technique called the Backdoor Roth IRA that allows you to get money into a Roth IRA regardless of how high your income is. You have to be careful with what you’re doing, but that’s what I’m going to go over this week.
When Might a Backdoor Roth IRA Make Sense?
In my last two posts (HERE and HERE) I talked about the two main factors that inform your choice between a Traditional or Roth IRA contribution. I’m not going to rehash that content here, but remind you that Roth IRAs have what’s called a phase-out limit.
What this means is that if you earn above these phase-out thresholds, you CANNOT contribute to a Roth IRA. If you’re in the middle of the range, the amount you can contribute is limited.
But what happens if you’ve maxed out your contributions at your employer-sponsored 401k (or similar) retirement program? How can you put more money away for retirement where there’s still some tax advantages?
A Backdoor Roth IRA might be your answer.
A Backdoor Roth IRA strategy is for high-income earners who want to save more for retirement. The conditions have to be right, as this strategy isn’t for everyone. But if you’re in a situation where your entire retirement nest egg is sitting in a 401k and you’ve maxed out your contributions to that plan, a Backdoor Roth might allow you to sock away more cash for retirement.
Why would getting money into a Roth IRA be useful? A Roth IRA affords you more flexibility vs. a Traditional IRA because Required Minimum Distribution (RMD) rules don’t apply to Roths, as they do Traditionals. You don’t have to take money out of your Roth IRA in retirement if you don’t want to. Not so with Traditional IRAs, where the IRS’s RMD rules force you to take money out every year.
Are You a Candidate for a Backdoor Roth IRA?
Before I dive into the step-by-step of how to do a Backdoor Roth IRA, a word of caution. It’s a good idea to talk with a financial planner or CPA before doing anything. If you make a mistake with a Backdoor Roth IRA, you might end up owing taxes to the IRS. [See Disclosures Here]
Now, to keep things simple I’m going to use a straight-forward example with 4 simple Yes/No questions.
You might be a good candidate to do a Backdoor Roth IRA if:
> Yes/No “My income is above the Roth IRA contribution phase-out thresholds (above),” AND
> Yes/No “I’ve maxed out my pre-tax contribution opportunities, such as an employer-sponsored 401k or similar retirement plan”, AND
> Yes/No “I don’t have ANY Traditional or Rollover IRAs”, AND
> Yes/No “I want to save more for retirement.”
You MUST answer YES to all for questions for a Backdoor Roth IRA strategy to make sense. Here’s what I mean:
For #1 – obviously, if your income is lower than the Roth IRA phase-out threshold, then you can contribute to a Roth IRA.
For #2 – if you’re a high-income earner, then it will almost always make more sense to contribute to your pre-tax plans rather than a Roth IRA. This is because of the tax issue I talked about before. Since you’re likely in a high tax bracket, it’s best to get a tax benefit today via a pre-tax contribution.
For #3 – this is where a lot of people get a nasty surprise if they’re not careful. If you have ANY outstanding Traditional or Rollover IRA balances, then doing a Backdoor Roth IRA strategy will run the risk of the IRS treating some of the amounts of your Backdoor Roth as a taxable event. You do NOT want that!
For #4 – you’ll only want to do this strategy if you have the desire and extra resources to save more for retirement.
Now if you answered YES to all four of those questions, let’s see how you’d do a Backdoor Roth IRA contribution.
Step 1: Open a Traditional IRA
Go to your favorite broker (Vanguard, Schwab, TDAmeritrade, etc) and open a TRADITIONAL IRA. Yes, I said Traditional. You’ll end up with a Roth IRA at the end of these steps, but it starts with a Traditional IRA.
Step 2: Make a Non-tax-deductible contribution to the Traditional IRA.
Refer to the maximum contribution amounts in the table below to see how much you can put in.
Step 3: Wait until you get your first Traditional IRA statement.
This waiting period is not critical but I recommend it anyway. The IRS has something called a “Step Transaction Doctrine.” In plain English, the IRS will look at a series of transactions in whole to make sure you’re not skirting around any IRS rules. Since there’s an income limit on Roth IRA contributions, some in the industry (including me) feel that waiting a few weeks before converting your Traditional IRA to a Roth IRA is best practice.
To put your mind at ease, the IRS has NEVER challenged a Backdoor Roth IRA strategy. In fact, language in the Congressional reports from the 2017 Tax Cuts & Jobs Act appears to bless the Backdoor Roth IRA strategy. But just to be safe, wait until you get your first monthly statement before moving on to the next step.
Step 4: Convert your Traditional IRA to a Roth IRA.
Contact the broker where your Traditional IRA account is and let them know that you want to convert it to a Roth IRA. They’re going to warn you that your conversion might lead to a taxable event. But as long as you have no other Traditional or Rollover IRA accounts with balances at the time you do the conversion, you should be okay. (But please consult with an Advisor or CPA first!)
Result: You now have money in a Roth IRA.
Even though your income was too high to contribute to a Roth IRA directly, by following Steps 1-4 you end up with the same result: Money in a Roth IRA.
This was a straight-forward example (if there’s such a thing in personal finance!). The money you now have in a Roth IRA will afford you the flexibility to use the funds when you need them in retirement.
Backdoor Roth Strategy When You Have Other IRAs
I’ve mentioned above how careful you have to be when doing a Backdoor Roth IRA contribution. This is especially the case if you have other Traditional or Rollover IRA balances.
The reason why you have to be careful is due to the IRS’s Aggregation Rule. This rule says that when you convert a Traditional IRA to a Roth IRA, you have to look at ALL your IRA balances and convert them proportionately. That’s a mouthful, so let me show you a simple example.
- Traditional IRA #1 has a balance of $95,000 and was built up with pre-tax contributions.
- Traditional IRA #2 is your new Traditional IRA that you want to convert to a Roth IRA. So you contribute $5,000 of AFTER-TAX money to this account.
Now, you want to convert that $5,000 to a Roth IRA. The IRS says, “Not so fast, my friend!”
Based on their Aggregation rules, the IRS will treat that $5,000 Traditional IRA conversion like this:
Total IRA Balances = $100,000
Traditional IRA #1 = 95% of the total ($95,000 / $100,000 Total IRA balance)
Traditional IRA #2 = 5% of the total
That $5,000 Roth IRA conversion will be treated as:
- $4,750 out of Traditional IRA #1 ($5,000 x 95%), and
- $250 out of Traditional IRA #2 ($5,000 x 5%)
Suppose you’re a married couple making $350,000 a year, which puts you in the 32% tax bracket.
You will have to pay tax on the amount you converted from Traditional IRA #1 equal to $1,520 ($4,750 x 32% tax). This is because the money in Traditional IRA #1 was funded with pre-tax contributions.
You won’t have to pay any tax on the $250 converted from Traditional IRA #2. But that’s of little solace after getting whacked with a $1,520 tax bill from Traditional IRA #1.
So what can you do to avoid problems with the Aggregation Rule? If your company-sponsored 401k (or similar) plan allows you to make rollover contributions INTO the plan, you can roll over all the money from Traditional IRA #1 into the 401k plan. You’d want to do this before starting the Backdoor Roth IRA process.
That way, when you go to convert Traditional IRA #2 to a Roth IRA, you won’t have any other IRA balances outstanding. Traditional IRA #2 will be 100% of your total IRA balances. So every penny of that $5,000 will end up in the Roth IRA without any tax consequences.
Sorry if that was confusing, but I want you to be aware of all the rules and pitfalls of this strategy.
Backdoor Roth IRA contributions are particularly attractive for high-income earners. High-income earners often find they can’t physically save enough money to sustain their lifestyle in retirement. This is because the IRS limits the amount you can contribute to a 401k and IRA.
A Backdoor Roth will help you save more money for retirement in a tax-advantaged account. And since a Roth IRA isn’t subject to Required Minimum Distribution rules, you’ll have more flexibility to use these funds when YOU need them.
As noted a couple of times, get some help from an Advisor or CPA before doing a Backdoor Roth. I’m not saying that selfishly given I’m an advisor. It’s for your protection and to make sure you don’t run into any unexpected tax issues.
I hope this short series on IRAs was helpful. It’s one piece to your retirement planning puzzle. If you want help looking at all your retirement savings options, get in touch with me and we can talk about your options.
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