How can I fund A Roth IRA if my income is too high to make direct contributions?
Although Roth IRAs provide many advantages for lower- and middle-income retirement savers, those with modified adjusted gross incomes (MAGI) above a certain amount are subject to a contribution phase-out schedule, adjusted for inflation each year, that eventually disallows direct contributions. In 2018, the schedule for married taxpayers filing jointly is $189,000 to $199,000; for single and head of household filers, it's $120,000 to $135,000 (this also applies to married individuals, filing separately who did not live with their spouse at any time during the year). Individuals with incomes above the top number in each category cannot contribute to a Roth.
However, all is not lost for those who exceed the limit. The removal of the $100,000 MAGI limit for Roth conversions in 2010 created a loophole in the tax code that allows high-income filers to legally funnel money into Roth accounts using a backdoor Roth IRA strategy. Here's how it works:
- Open a traditional IRA with your IRA custodian of choice. (It is usually easiest, but not necessary, to use the same custodian that holds your Roth conversion IRA - or where you plan to open your Roth.)
- Make a fully nondeductible contribution to your traditional IRA. The contribution limits in 2018 are $5,500 for those under age 50, plus an additional $1,000 catch-up contribution for those aged 50 and above. If your MAGI exceeds the Roth limit, as described above, you are automatically ineligible to deduct your contribution if either you or your spouse - if you're married - participates in an employer-sponsored qualified plan of any kind. If neither you nor your spouse is a qualified-plan participant, simply refrain from reporting your traditional IRA contribution as a deduction for MAGI on your 1040.
- Next, convert the traditional IRA balance into a Roth IRA. Because the MAGI threshold for contributions does not apply to conversions, the income limitation is effectively thwarted.
- Repeat this process every year that your MAGI is too high to allow you to make a direct contribution to your Roth IRA.
Taxes and Other Considerations
This backdoor strategy works best if you don't already have a traditional IRA because it will leave you owing no taxes on your contribution. If you do have a traditional IRA that you have funded with contributions for which you took a deduction, however, the tax benefit will be reduced and computing your taxes becomes more complicated. Understanding this takes time, but it’s worth paying attention to the following three situations - or discussing them with your tax advisor.
Situation 1: You Owe Zero Taxes
You are 40 years old and make $200,000 a year. You open a new IRA and make a nondeductible $5,500 contribution. You then convert this $5,500 to a Roth IRA. You have no other traditional IRAs. Your tax bill for the conversion is zero because you did not deduct your contribution.
Situation 2: You Owe Taxes on All Your Previous IRA Balances
Your actions and circumstances are identical to Example 1, except that you also have a traditional IRA rollover account that was funded entirely with deductible contributions: You got a tax deduction when you made the contribution. If you try to convert the entire amount you have in IRAs - both this year's $5,500 nondeductible contribution and the rest of your IRA balance - you will have a tax bill. How much you owe depends on how large that rollover IRA is.
If the IRA is worth $49,500, $4,950 of your $5,500 would be taxable:
Nondeductible contribution to traditional IRA = $5,500
IRA rollover balance = $49,500
Total of contribution plus IRA balance = $55,000 ($5,500 + $49,500)
$5,500/$55,000 = 0.1 = 10%
$5,500 x 10% = $550 nontaxable conversion balance
$5,500 - $550=$4,950 taxable conversion balance
Only the $550 will be subtracted from the total contribution as nontaxable.
If the IRA is worth $3,000, only $1,925 would be taxable.
Nondeductible contribution to traditional IRA = $5,500
IRA rollover balance = $3,000
Total of contribution plus IRA balance = $8,500 ($5,500 + $3,000)
$5,500/$8,500 = 0.65 = 65%
$5,500 x 65% = $3,575 nontaxable conversion balance
$5,500 - $3,575 = $1,925 taxable conversion balance
If you have one or more IRAs that you funded with deductible contributions, even the backdoor strategy cannot keep you from owing taxes on a Roth conversion. You can't open a second IRA and roll over only that second account and owe no taxes, as in Situation 1. Your Roth IRA, by the way, will just have the $5,500 in it. Your other IRAs won’t be folded into it - they’ll just be included in the government’s tax calculations. The tax bill will be assessed regardless of whether a new or current account is used.
Situation 3: You Owe Taxes Only on Some IRAs
For a backdoor Roth conversion, the government will calculate taxes only using IRA balances funded with deductible contributions. These will not be included if you have IRA balances you funded with after-tax (nondeductible) contributions.
Imagine you are the same age with the same income as in the previous examples. You could have several IRAs that were funded partly with deductible contributions and partly with nondeductible contributions. For the sake of simplicity, though, imagine you have just two traditional IRAs, one funded each way:
IRA 1: $60,000 - funded with deductible contributions
IRA 2: $40,000 - funded with nondeductible contributions
You open a third traditional IRA with a $5,500 nondeductible contribution and convert that balance to a Roth IRA. Your tax calculation would only include IRA 1, the deductible-contributions IRA.
Nondeductible contribution to traditional IRA = $5,500
IRA 1 = $60,000 (total IRA balance made with deductible contributions)
$5,500 + $60,000 = $65,500
$5,500/$65,500 = 0.08 = 8%
$5,500 x 8% = $440 nontaxable conversion balance
$5,500 - $440 = $5,060 taxable conversion balance
Situation 4: One Other Way to Escape Taxes
If you or your spouse participates in a traditional qualified plan at work that accepts rollovers of pretax (deductible) IRA balances, then you have another avenue with which you can avoid tax when you use the backdoor strategy to fund a Roth. Here’s how: Roll over all your deductible IRAs before starting the conversion process. Then, open a new IRA with a $5,500 nondeductible contribution and convert that amount into a Roth IRA. Your tax bill will be zero because the government doesn’t include qualified-plan balances in calculating the tax on a backdoor Roth conversion. It also excludes IRAs made with nondeductible contributions from the calculation.
The Bottom Line
You can use the backdoor strategy to get into a Roth IRA in all these situations. You save the most if you do not have pre-existing traditional IRA balances that must be factored into your tax bill (Situation 1) - or if your employer’s qualified plan allows you to fit into Situation 4.
Of course, this strategy is unnecessary if your employer offers a Roth 401(k) retirement plan, and you are not making the maximum possible contribution. Roth 401(k) plans let you contribute up to $18,500 for 2018 in after-tax dollars that you can collect tax free when you retire. If you have only contributed $5,500 to your Roth account in the plan, then it would be simplest to contribute the remaining $13,000 for 2018 before opening a backdoor IRA. One possible exception to this rule could be if you are dissatisfied with the investment choices that are offered inside the plan and wish to explore alternative options elsewhere.
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: https://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:https://www.investopedia.com/articles/personal-finance/040815/converting-traditional-ira-savings-roth-ira.asp
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.
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.
We have produced a complimentary guide and toolkit to help our high-earning clients.
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®
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.