Contributing to a Roth IRA Regardless of Income

Roth IRAs are retirement accounts that allow a saver to invest after-tax money in a protected wrapper such that she never pays tax on the growth if the money is used after age 59.5. Relative to a traditional IRA, Roth accounts have a number of advantages that can make them amazing planning tools for young investors.

To limit their use, the government restricted Roth contributions to those making less than a certain amount. In 2016 that modified adjusted gross income number is $194,000 for joint filers and $132,000 for single filers with phase-outs staring at $184,000 and $117,000 respectively. 

Fortunately for savers with income above those levels, there are still ways to get money into a Roth account—it just takes an extra step. (For related reading, see: The Advantages of Automating Your Financial Life.)

Backdoor Roth Contribution

I’m going to use Joe and Jane Smith as my examples. Both are lawyers, 35 years old, married, and have a joint income of $300,000 a year. They are maxing out their 401(k)s and still have extra money to save for retirement.

First, even though Joe and Jane contribute to their 401(k)s at work, they can still both contribute to traditional IRAs as well. The catch is that if they make more than the IRS income threshold, the contributions are not tax-deductible. In Joe and Jane’s case, since they are married, both have plans offered through work, and collectively earn more than $118,000, they don’t get the tax deduction (the figures would be different had they been single or not covered by plans through work. For 2016, individuals under age 50 are limited to contributions of $5,500 while people 50 and older can contribute $6,500. 

Second, under current law, all IRAs can be converted into Roth accounts regardless of the account owner’s income as long as she pays income tax on the pre-tax dollars being converted. In Joe and Jane’s case, since they make too much money to take the tax deduction, they are contributing after-tax dollars. Therefore, when they go to make their conversions, they aren’t required to pay any additional tax. This conversion is equivalent to contributing the money directly into a Roth.    

Third, assuming no changes to the tax law, Joe and Jane could do this conversion on an annual basis for as long as they have earned income and are younger than age 70.5. Using a future value equation, if Joe and Jane were to each contribute $5,500 per year for the next 35 years and earn annual returns of 7%, they would have a retirement asset of $1,520,605 that could be used entirely tax-free. (For related reading, see: Why You Should Have a Roth IRA.)

An Important Caveat

If Joe and Jane had 401(k)s from previous employers that were rolled into traditional IRAs, they would need to add an extra step. Investors cannot pick and choose which IRA dollars they convert to a Roth. For example, if Joe had $100,000 of pre-tax money in one IRA and $5,500 of post-tax money in another IRA, he couldn’t simply convert the post-tax money and call it a day. The government looks at all of the IRA accounts collectively and will assume the assets get converted on a pro-rated basis. In Joe’s case, that means if he tries to convert $5,500 of the $105,500 in total IRA assets, he will have to pay income tax on 94.79% of the transaction.

One way to avoid this scenario is for Joe to roll his pre-tax IRA into his 401(k) at work. By doing this, he has eliminated the pre-tax IRA in the eyes of the government and he is now able to convert the post-tax IRA to a Roth without paying additional tax. Alternatively, he could convert the entire pre-tax IRA to a Roth, pay the income tax and avoid the proration rules. However, this scenario should be used with caution as all of the IRA assets converted to a Roth are going to be taxed as ordinary income and large conversions can easily push the investor into a higher tax bracket.

Remember that every situation is different. As with all things tax and retirement planning related, consult your tax and/or financial advisor before making any decisions for your own accounts. (For related reading, see: The Hidden Cost of Hedge Funds.)