You know those limitations the IRS imposes when it comes to making a Roth IRA contribution? The ones that say if your income exceeds Level X, you’re not entitled to contribute to a Roth IRA? But this is something of a farce! If your income is over the limits for Roth IRA contributions you can still make contributions anyway. How? By using the backdoor Roth IRA strategy.
What is the backdoor Roth IRA strategy and how can you save money even when you exceed the income limitation requirements?
Here’s how to contribute even if you don’t qualify.
Why Contribute to a Roth IRA?
Roth IRAs are an important addition to your overall retirement planning because they introduce the concept of income tax diversification to your portfolio.
With a Roth IRA, your plan contributions are not tax-deductible, however those contributions — plus the investment earnings on them — can be withdrawn tax-free if you are at least 59 ½, and you have participated in a Roth IRA plan for at least the previous five years.
That tax-free provision can be especially important to high-income taxpayers who would normally be excluded by Roth IRA income limitations. As a high-income earner, you’re very likely to also be a high retirement income earner, with a real need for some tax-free income when you retire.
You can contribute to and build upon your future tax-free Roth IRA plan, even though IRS regulations say that your income exceeds the contribution limits.
Roth IRA Income Limitations
Before getting into the mechanics of how you can do this, let’s first review the limitations.
Under current IRS regulations, the income limit for married couples making contributions to a Roth IRA is set at $191,000 or more. For single taxpayers, the limit is $129,000 or more. Both figures are for the 2014 tax year.
Unlike income limitations for traditional IRAs, which simply remove the tax deductibility of contributions beyond the income limits, Roth IRA income limits eliminate your ability to contribute to the plan at all.
But not to worry, there is a way around those income limits.
The Workaround for a Roth IRA
The workaround on Roth IRA contributions if your income exceeds the limits is simple. You make a nondeductible contribution to a traditional IRA, and then roll that IRA over into a Roth IRA.
Interestingly, the contribution limits on traditional IRAs are actually substantially lower than what they are for Roth IRAs. If you are married filing joint and covered by an employer retirement plan, the tax deductibility of a traditional IRA contribution disappears at an income of $116,000. If you’re single, the tax deductibility of the traditional IRA contribution disappears at an income of $70,000.
If your income exceeds the limits for Roth IRA contributions, that is already well above the threshold for deductible traditional IRA contributions as well.
Not a problem. Here’s your backdoor IRA solution.
You can make a contribution to a nondeductible traditional IRA — up to $5,500, or $6,500 if you are age 50 or older, then convert the traditional IRA to a Roth IRA.
Simple, and it happens every day. The IRS may as well scrap the Roth IRA contribution income limits — they’re not stopping anyone anyway.
There are no restrictions on this maneuver, and you can make the switch within days of funding your nondeductible traditional IRA plan.
The Backdoor Roth IRA Contribution Wrinkle
The backdoor Roth IRA contribution technique does have one complication. Generally speaking, there is no income tax liability created by rolling over the traditional IRA contribution into a Roth IRA, since the traditional IRA contribution is non-tax deductible.
Because of this, a backdoor Roth IRA contribution works best if you don’t already have money sitting in traditional IRAs. This is especially true if you roll the traditional IRA into the Roth IRA before potentially taxable earnings accumulate on the contributions sitting in the traditional IRA. The money moves from one account to the other, and there will be no income tax liability in the transfer.
The complication is that the tax on the transfer is calculated based on all of your traditional IRAs, even if those IRA funds that are not part of the direct transfer. So if you have a large amount of traditional IRA money already in place, the rollover contribution into a Roth IRA may not be as attractive from a tax standpoint.
However, there is a way to deal with that as well.
What to do With Older IRAs
Many people are entirely unaware of this, but it is possible to roll traditional IRAs into an employer-sponsored 401(k) plan. However, you can only do this if the employer plan allows such rollovers.
If you can consolidate all of your traditional IRA plans into your employer-sponsored 401(k), that will clean up your IRA slate, and enable you to make rollovers from new traditional nondeductible IRA contributions, into Roth IRAs essentially tax-free.
If your income exceeds the Roth IRA contribution income limits, have you taken advantage of this backdoor contribution method?