One of the nice things about making more money is that you have the opportunity to save more money.
But one of the downsides of making more money is that you eventually run into some restrictions on where you can save it.
Specifically, the IRS limits the amount you can contribute to a Roth IRA and the amount you can deduct for contributions to a Traditional IRA based on your income. Once your income reaches a certain point, those accounts are limited in their use.
However, there’s a loophole that can allow you to keep contributing to a Roth IRA no matter how much money you make.
It’s called the backdoor Roth IRA. Here’s how it works.
The Basics of a Backdoor Roth IRA
For 2017, Roth IRA contributions are not allowed once your modified adjusted gross income exceeds $196,000 for married couples, or $133,000 for single filers (source). And if you’re participating in an employer retirement plan like a 401(k), you would also be prohibited from deducting Traditional IRA contributions at that income level.
But there are two additional provisions that, when used together, can allow you to work around these limits:
- You’re allowed to make nondeductible contributions to an IRA no matter how much money you make.
- You’re allowed to convert money from a Traditional IRA to a Roth IRA no matter how much money you make.
So let’s say that between you and your spouse, you make more than the $196,000 limit for contributing to a Roth IRA. And let’s say that you also participate in a 401(k), meaning you can’t deduct Traditional IRA contributions.
Here are the workaround steps you could take to get money into a Roth IRA:
- Open a new Traditional IRA.
- Contribute to your new Traditional IRA. You won’t get a tax deduction for the contribution, but as you’ll soon see, that won’t matter.
- Wait until you receive your first statement from your new Traditional IRA, which should be in about one month. There is some disagreement around how long you should wait, but one month seems to be a fairly safe bet.
- Convert the money in your new Traditional IRA to a Roth IRA. Whichever company you have your IRA with can help you do this (it’s pretty straightforward).
- As part of the conversion you will be taxed on any growth that’s happened since contributing to the Traditional IRA, but since it’s only been a month or so, that should be minimal. You won’t be taxed on the amount you contributed, since that was already after-tax money.
And that’s how a backdoor Roth IRA works. And now that your money is inside a Roth IRA, you’ll eventually be able to withdraw it tax-free.
Of Course, There’s Always a Catch…
If you don’t have any existing Traditional IRAs, SEP IRAs, or SIMPLE IRAs, then it really is that simple. But if you do, there’s a big caveat you need to be aware of.
When you convert from a Traditional IRA to a Roth IRA, the IRS considers all of your IRAs to be part of one big pot, and it considers the money you convert to come proportionally from each part of that pot.
Here’s an example to show you what that means:
- James has $20,000 in a Traditional IRA. All contributions to that IRA were deductible, so this money has never been taxed.
- This year James makes too much to deduct contributions to a Traditional IRA, but he likes the idea of a backdoor Roth IRA. So he opens a new Traditional IRA, completely separate from his old one, and makes a $5,000 nondeductible contribution.
- He converts the $5,000 in that new, nondeductible Traditional IRA to a Roth IRA.
- From the perspective of the IRS, that $5,000 conversion was actually made from a single $25,000 IRA, even though James has two separate accounts.
- Since 80% of James’ combined IRA money has never been taxed, 80% of his Roth IRA conversion will be taxed.
- This means that $4,000 of James’ conversion will be taxed. Assuming James is in the 28% tax bracket, he will owe $1,120 on the conversion. And it may be more when you include state income taxes.
In other words, having an existing Traditional IRA that you’ve made deductible contributions to throws a big wrench in your plans to do the backdoor Roth IRA by subjecting a potentially significant portion of your conversion to taxes.
The Way Around the Catch
All hope is not lost. There’s a way to do the backdoor Roth IRA tax-free even if you have money in an existing Traditional IRA, SEP IRA, or SIMPLE IRA.
All you have to do is roll all of that existing IRA money into a 401(k) or other employer retirement plan BEFORE executing the backdoor Roth IRA. Then, when you convert your nondeductible contributions to a Roth IRA, there won’t be any other IRA money to look at and you’ll avoid the big tax hit.
Now, this may or may not be possible depending on your situation. First, you have to currently be participating in an employer retirement plan. And second, your plan has to accept rollovers from all of your existing IRAs, which they may or may not do. You can ask your employer for specific details.
It may also not be desirable for other reasons. Many 401(k)s are littered with high fees, and one of the advantages of having your money in an IRA is that you have much more control over both your investment options and how much you pay.
But if it’s allowed and if your 401(k) has reasonable investment options at a reasonable price, it can be a worthwhile move that frees you up to do the backdoor Roth IRA.
The backdoor Roth IRA is a legitimate tactic that’s used by a lot of people every single year.
But there are a number of moving parts and a number of potential hang-ups, so it makes sense to tread carefully and potentially even seek out the help of a professional before making any final moves. A financial planner could help you decide whether it’s the right move, and an accountant could help you navigate the tax issues.
Still, when it’s done right, a backdoor Roth IRA gives you access to a significant amount of tax-free money you wouldn’t have otherwise had.