How can I fund A Roth IRA if my income is too high to make direct contributions?
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.
- 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
- 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
Mark Struthers CFA, CFP®
One way to contribute to a Roth IRA, if you make more income than the limits allow, is to utilize a back-door Roth IRA conversion.
Sound complicated? A little bit, but in theory, this process is actually pretty simple. First thing, although there are income limitations to funding a Roth IRA, there are no income limitations to converting to a Roth IRA. So if you were to contribute to a traditional IRA, which does not have contribution rules that are determined by your income, in theory, you could convert to a Roth IRA and all you have to do is pay taxes on the full amount of the conversion which could be up to $6500 (depending on your age).
Once you have converted your IRA to a Roth IRA you will have to pay taxes on the conversion, but moving forward, your growth and your distributions from the Roth IRA will be tax-free.
The Roth IRA conversion is a commonly used strategy for those that earn an income which is above the asset limits for contributing to a Roth IRA. Here's a great article from here on Investopedia going into a little bit more detail about Roth IRAs and their contribution limits: http://www.investopedia.com/university/retirementplans/rothira/rothira2.asp
This is also a great article with a video from here on Investopedia which goes into some very good detail about Roth conversions that is definitely worth taking a look at:http://www.investopedia.com/articles/personal-finance/040815/converting-traditional-ira-savings-roth-ira.asp
Roth IRA contributions are in accordance with your Modified Adjusted Gross Income (MAGI). In 2016:
- If your MAGI is $117,000 or below, you can make a full contribution ($5,500 or $6,500 you're age 50 or older)
- If your MAGI is more than $117,000 but less than $132,000, you can make a reduced contribution
- If your MAGI is more than $132,000, you are ineligible to make a contribution
- If your MAGI is $184,000 or below, you can make a full contribution ($5,500 or $6,500 you're age 50 or older)
- If your MAGI is more than $184,000 but less than $194,000, you can make a reduced contribution
- If your MAGI is more than $194,000, you are ineligible to make a contribution
If your income is too high, a traditional non-deductible IRA contribution (also known as the "back-door Roth IRA") might be a viable solution if you don't have any other IRA assets. Any gains will be taxable upon the conversion (if the conversion wasn't made simultaneously as the contribution).
Keep in mind if you have other IRA assets (such as traditional, SIMPLE, and SEP IRAs), the pro-rata rule will apply, where distributions made from an IRA (pre-tax and after-tax) will be proportional to each other. Essentially, they are categorized as one entire amount instead of being separate.
Note: The pro-rata rule excludes employer-sponsored plans such as 401(k)s, 403(b)s, and profit-sharing plans.
If you have any further questions, I'd be happy to help.
Congratulations on being in that envious position. Earning a high income does not exclude you from making a Roth contribution. You may not do so directly, but indirectly through a two-step process, can accomplish the same mission.
Assuming you have no other IRA (traditional, SIMPLE, SEP) account, first open a traditional IRA account and make a full non-deductible IRA contribution, then immediately convert to Roth. Timing is everything. If you wait too long and let the money grow in the traditional IRA account, you may have to pay some tax on the earnings when you do the final conversion. For example, you made $5,500 on a non-deductible IRA to a traditional IRA for 2016. As soon as the money was deposited into the account, you requested a Roth conversion of the full amount. After that, you can invest to your heart’s content. On the other hand, you made the same deposit to the traditional IRA. Instead of the immediate conversion, you heard a financial tip from a friend and bought a fund. That $5,500 grew to $6,000 by the year end. Now, when you made the full conversion, you must pay the tax on that $500.
Assuming you have one or more traditional IRA accounts, you can’t implement the aforementioned method as you were forbidden to cherry pick what you would like to convert. There’s a pro rata rule to follow, and it can get complicated. Should that be the case, you need to consult with a professional CFP® to see if it’s indeed, to your best advantage to do the conversion and pay the tax. The last thing you want to achieve is to pay the current higher tax, only to find out you will have a much lower tax bracket at retirement.
If you make too much money you cannot contribute directly to a Roth IRA.
However, you can contribute to a Nondeductible (back door) IRA regardless of your income level. You can also convert that Nondeductible IRA into a Roth IRA to create that “back door” method. In general this is a great idea. You are allowed to contribute $5,500 ($6,500 if over 50) each in 2016. Usually it makes sense to wait 30 – 60 days before doing the conversion.
One thing I will point out is please make sure you are aware of the Pro rata rule.
If you have more than one IRA, a rollover, one you opened years ago, a SIMPLE IRA, SEP IRA etc. (not existing Roth IRA) along with your nondeductible IRA you will be required to act as if all of the accounts are one for the conversion. You will be taxed on a proportion of your Deductible and Nondeductible IRA’s, therefore you may be hit with and unexpected tax bill. With the pro rata formula you take the total year end amount of all your IRA’s (except Roth IRA’s) and divide that into the total balance of all Nondeductible amounts in your IRA’s. That percent is then the tax free portion of the rollover. All other amounts will be taxable.
Finally, if you do not have any other IRA’s and the one(s) you are converting do not have any investment gains you will be able to convert tax free the entire amount for that year.
You should consult with a CPA or qualified Financial Advisor who understands your personal circumstances before acting.