Have you been shut out of contributing to a Roth IRA because your income is too high? In 2015, a single taxpayer with a modified adjusted gross income (MAGI) of $116,000 will see his/her allowable contribution reduced as his income increases, until at $131,000 the taxpayer can’t contribute at all. Married taxpayers face an even greater disadvantage: They have the same problem when their MAGI falls in the $183,000 to $193,000 range, or the equivalent of $91,500 to $96,500 per spouse.
Unless all your friends, family and coworkers are as well off as you are, you might want to keep this problem to yourself. But it doesn’t have to be a problem for long: The solution is a backdoor Roth IRA, and we’ll tell you how it works.
Why Contribute through the Back Door?
A backdoor Roth IRA is the name of a method, not a product. It describes a number of careful steps people too affluent to qualify for a Roth IRA can take to get money into one of these accounts in a roundabout way. It's basically a tax loophole.
Why would you want to go to all this trouble to contribute to a Roth IRA, which doesn't even lower your taxable income for the year (the money you put in a Roth is after-tax earned income), especially when the contribution limit is relatively low? The IRS restricts how much anyone, not just high-income earners, can contribute to a Roth to $5,500 annually ($6,500 if you’re 50 or older).
The trouble is worth it because even small contributions to a retirement account can become large over time when invested properly, and Roth IRAs don’t have required minimum distributions (RMDs), so you can let your balance grow in perpetuity. Even better, if you do choose to withdraw any Roth money once you're old enough to avoid penalties, the withdrawals are tax-free – including all the interest you earned over the years on your savings in the account.
With a traditional IRA, you have to start withdrawing a certain amount from your account each year once you reach age 70½ and what you withdraw is taxed as regular income. If you don’t take RMDs, you’ll pay steep penalties to the IRS – a huge waste of money. The same is true with a 401(k) unless you’re still working.
So what if a Roth doesn’t require you to take RMDs? Isn’t the whole point of having a retirement account to use those assets when you’re older? Well, yes, but now that you’re a high-income earner trying to maximize your retirement savings, you need to start thinking like a high net-worth individual, even if your net worth isn't that high yet.
Think Like You’re Rich
You might not need to take any distributions at age 70½ because you’re still working or have plenty of assets to draw on from non-retirement accounts. You might want to leave your money in your retirement accounts for as long as possible so it can keep growing at the accelerated rate that your account’s tax advantages make possible. You might want to bequeath a substantial inheritance to your children so they have more options in life than you did, or you might want to leave a legacy (see Ethical Investing: Leaving an Ethical Legacy) by making a huge contribution to your favorite charity. In any case, having as much of your retirement savings as possible in a Roth – where you, not the IRS, get to decide when to take your money out – gives you more options and more potential to keep growing your nest egg (see The Complete Guide to Retirement Planning For 50-Somethings).
Making the Conversion
What the IRS hasn’t limited since 2010 is who can convert a traditional IRA to a Roth IRA based on income. Traditional IRAs also have restrictions based on income, but whereas the tax code flat out cuts you off from contributing to a Roth when your income reaches a certain level, the tax code still lets you contribute to a traditional IRA no matter how high your income gets. It just doesn’t let you take a tax deduction for your contributions. For 2015, when your income reaches $70,000 as a single taxpayer or $116,000 as a married taxpayer, you can’t take a tax deduction for your traditional IRA contributions, but you can still contribute up to $5,500 annually ($6,500 if you’re 50 or older) using after-tax dollars.
You might think that this sounds exactly like contributing to a Roth, and you’re right. You’re making an after-tax contribution, and your money will be able to grow tax free. The difference is that with a traditional IRA, you have to pay tax on the distributions. While tax-free growth is a nice perk that you don’t get with non-retirement accounts, if you’re paying tax on both the contributions and the distributions, you’re not going to be that much better off than if you were socking away money in a regular, non-tax-advantaged account. That’s why you want to take the added step of converting your traditional IRA to a Roth. Vanguard estimates that a taxpayer who starts making maximum backdoor contributions at age 30 could save $250,000 on taxes by age 90.
There’s a second way to do a backdoor Roth, and that’s with a 401(k) plan. Similar to the traditional IRA method just described, you contribute after-tax dollars to your 401(k), instead of the pre-tax dollars you normally contribute. Then you do an IRA rollover to get that 401(k) contribution into a Roth so the distributions won’t be taxable.
Should You Do It?
If you want to do a backdoor Roth, you need to do it carefully to avoid incurring the tax bill you’re trying to avoid. If you already have untaxed traditional IRA assets, you must follow the pro-rata rule when you do your backdoor conversion. You might be able to get around this rule if you have an employer-sponsored plan or self-employed 401(k) that lets you roll in IRA assets. (Learn more in 401(k) Plans For The Small Business Owner.) If you do make a mistake, you may have a small window to undo it through a conversion recharacterization. It’s a good idea to consult a financial planner or tax advisor for help executing your backdoor IRA strategy correctly. (For more on how to complete this process and minimize your tax bill, see How can I fund a Roth IRA if my income is too high to make direct contributions?)
You may have a much simpler way to accomplish the same goal if your employer offers a Roth 401(k) retirement plan where you aren’t maximizing your contributions. Roth 401(k)s have a contribution limit of $18,000 in after-tax dollars in 2015 ($24,000 if you’re 50 or older). Your employer can offer matching contributions to this account, too. Be aware that Roth 401(k)s have the same RMD rules as regular 401(k)s. The advantage of using a Roth 401(k) is that it’s simpler and you can contribute more; the disadvantage is the RMDs. For more, see 401(k) Plans: Roth or Regular?
The backdoor conversion process isn’t necessarily something you do just once. To take full advantage of a backdoor Roth, you should do it every year that your income exceeds the Roth contribution threshold. That is, as long as the tax code follows current rules.
The Bottom Line
The biggest drawback of making a backdoor Roth contribution is that the pro-rata rule can make a significant percentage of any earlier, tax-deductible traditional IRA contributions taxable. However, many taxpayers will be able to complete a backdoor Roth contribution without incurring a tax bill. Even with a tax bill for the conversion, it may still be worthwhile. The Roth IRA’s tax-free growth, tax-free distributions and lack of RMDs make it a great vehicle for funding your own retirement and passing on wealth to your heirs.