How can I fund A Roth IRA if my income is too high to make direct contributions?

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December 2016
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A Backdoor Roth is often a good option for a high earner. You would make non-deductible contributions to your IRA, then convert them to a Roth. The main rub is if you have current deducible IRA (Simple, SEP, Traditional, etc..) funds (Roth funds do not matter). They treat them all (the IRAs) as one account and any conversion would be seen as a portion of pre and post tax dollars.

Example:

  • You have $8,000 in pre-tax dollars (normal deducted contributions) 
  • You then make $2,000 non-deductible contributions to an IRA for the Backdoor Roth (this assumes no gain on the $2,000)
  • If you wanted to covert the $2,000 to a Roth
    • $1,600 would be taxable (80% x $2,000)
    • $400 would be tax free (20% x $2,000)
    • The 80% comes from pre-tax dollars divided by the total IRA account value ($10,000 ÷ $8,000 = 80%) 
      • Same with the 20%
    • This is known as the Pro-Rata Rule
    • You would owe ordinary income tax on $1,600 dollars.

If you want it done for 2016 taxes, you might want to move fast. The deadline for my clients is 12/22, with the custodian I use.

Other tax-friendly options are:

  • A charitable contribution the same year as the conversion to offset any conversion tax
  • In and/or out of service 401(k) Roth Conversions (you can make non-deductible contributions up to $53,000)
  • US Savings Bonds
  • Tax-efficient accounts
  • Muni-Bonds

Other concerns:

  • Even if you have no other IRA dollars, there would still be tax on any earnings
  • Be careful of insurance products being sold as substitutes for Roths
  • The guidance from the IRS as to how long the funds need to be in the account before conversion is not clear -- good to have in there at least a day or two
    • Please double check with your Roth provider

Good Luck!

Mark Struthers CFA, CFP®

www.SonaFinancial.com

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