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A Roth IRA Savings Strategy for High Earners

Raise your hand if you like paying more in taxes than you need to? Yeah, I didn’t think so. If your answer is like most Americans and you make a sizable income, then a backdoor Roth IRA is a strategy you may want to consider. However, before explaining how to unlock this financial planning tool to your advantage, it is important to know the following Roth IRA phase-out limits set forth by the IRS:

  • Single: $117,000 - $132,000
  • Married: $184,000 - $194,000

In addition, one needs to know that when an active participant in a company-sponsored retirement plan exceeds the income limits listed above, then that person (in most instances) is disqualified from making deductible IRA contributions. The alternative for that person is to then contribute to a non-deductible IRA - meaning a non-deductible IRA is funded with after-tax dollars. The only advantage to the owner is that their money will grow tax deferred until distributions begin at normal retirement age (59½). Any growth is taxable and pulled first whenever the owner starts making withdrawals. A Roth IRA, on the other hand, allows the owner to grow their after-tax contributions on a tax-deferred basis and take tax-free withdrawals at full retirement. Translation, a Roth IRA is always better than a nondeductible IRA. (For more, see: Is a Backdoor Roth IRA Suitable for You?)

Entry Through the Back Door

You are probably wondering how does a backdoor Roth IRA fit in with all this financial mumbo jumbo? Think of the concept this way, the “backdoor” is usually the best entry point for a person who intends to sneak in while going undetected. Inserting this into the IRS’ world, an investor who exceeds the Roth IRA phase-out limits is able to use the backdoor Roth as means to bypass these limits without being accessed the typical IRS penalties. 

So how does a disqualified Roth investor actually slip past the IRS? Their “backdoor way in” is in its basic form, a two-step process. The first step is to contribute to a non-deductible IRA, followed by converting those funds to a Roth IRA. The timing of when that conversion occurs is important to make note of because the IRS might take you to court and challenge your contribution if you are too careless.

Two Caveats

How does one avoid setting off the IRS alarms? Actually there are two hurdles to consider when deciding whether or not a backdoor Roth strategy is appropriate for you. The first roadblock you need to evaluate is the IRA Aggregation Rule and the second one is called the "step transaction doctrine." 

The IRA Aggregation Rule

Red alert to any investor who owns multiple pre-tax IRAs. All of your pre-tax IRAs are treated as one account when calculating the tax consequences of a Roth conversion. In other words, the IRS’ aggregation rule requires an owner of multiple IRAs to include a proportionate amount of any pre-tax IRA balances (traditional IRAs) with their after-tax IRA balances (non-deductible IRAs) whenever performing a Roth conversion. (For more, see: How Can I Fund a Roth IRA if My Income is Too High?)

Example: An attorney, Atticus Finch, currently exceeds the IRS’ income limits to be able to contribute to a Roth IRA and also has a traditional IRA worth $100,000. Atticus is considering whether or not he should convert his recent non-deductible IRA contribution of $5,500 to a Roth IRA. Unfortunately for Atticus, his $5,500 non-deductible amount gets rolled in with the $100,000 of pre-tax IRA funds when he goes to complete the Roth conversion. This means only 5.2% ($5,500 / $105,500) of the conversion is sourced from the non-deductible IRA, and the other 94.8% comes from the traditional IRA. Needless to say, Atticus isn't happy because he just paid income taxes on 95% of his $5,500 after-tax conversion. While it’s not quite double taxation, it sure feels like it. Yikes.

What can Atticus do to prevent this problem? One answer is to rollover all traditional IRA funds to his law firm's retirement plan. This is because 401(k), 403(b), and other employer-sponsored retirement plans are excluded from the IRA aggregation rule. However, employer-sponsored SIMPLE IRAs and SEP IRAs are truly IRAs, and therefore included for the sake of this rule.

The Step Transaction Doctrine

Another issue to be considered is the "step transaction doctrine," which allows the tax court to review what are, in fact, two separate steps of a transaction to be deemed one integrated tax event. The key to avoiding this is the timing element. So when an investor deposits money into a non-deductible IRA and then converts those funds into a Roth IRA within a matter of days, the IRS may consider this a single integrated tax even. The consequences of this are that the IRS disallows it as an excess Roth contribution and assesses the investor a penalty tax of 6%. Keep in mind that the 6% penalty accrues each year the money remains in the Roth account.  

The safest way to get around the IRS disallowing a backdoor Roth contribution is to wait at least one year to convert the non-deductible IRA funds to a Roth IRA. And a way to reinforce that both transactions are independent of one another is to invest the non-deductible funds while you wait to do the Roth conversion. Any gains from the non-deductible IRA are taxable the following year you convert them. However, the tax benefits of the Roth more often offset this one-time taxable event. Plus, having investment gains in your account is a good thing.

Helpful tip: Never put anything in writing that states what you are doing is a backdoor Roth IRA. Doing so gives the IRS ammunition if they ever question your transactions as being singular in nature. (For more, see: Pros and Cons of Creating a Backdoor Roth IRA.)

Summary Guide to Performing a Backdoor Roth

  1. Confirm there are no other pre-tax IRAs.
  2. When there are, rollover funds to a 401(k).
  3. Contribute to non-deductible IRA.
  4. Invest funds in non-deductible IRA.
  5. Keep money in non-deductible IRA for one year.
  6. Convert to Roth IRA.