A Backdoor Roth IRA Method If You Make Too Much Money

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We all know about Individual Retirement Accounts (IRAs) created by the US government. These savings tools can help you grow your nest egg and enjoy a break at tax time too.

But there's a special kind of IRA known as the Roth IRA. Although with Roth accounts you have to pay taxes up front, in the long run, they can save you a bundle.

Within your Roth IRA, your money grows tax-free. And assuming you follow certain rules, your withdrawals can be tax-free as well. Throw in benefits such as no required minimum distributions and the ability to withdraw your money at any time, and the Roth IRA becomes a powerful retirement and financial planning tool.

Not sure if a Roth IRA is for you? Check out Roth IRAs vs. Traditional IRA comparision.

Unfortunately, Roth IRA contributions are limited to $6,000 each year, with an extra $1,000 limit for those who are age 50 or over. But more importantly, there are limits on your income level. For 2020, here are the phase-out limits:

Filing status Phase-out begins No contributions allowed above
Single $124,000 $139,000
Married, filing jointly $196,000 $206,000

It was thought if you made above this level you were out of luck. But there's a backdoor Roth IRA method no matter your income level. It's all legal and legit. If you find out how, keep reading.

What Is a Backdoor Roth IRA?

Very simply put, a backdoor Roth IRA converts the assets in a traditional IRA to a Roth account. Everyone, regardless of income, is eligible to contribute the lesser of their earned income or the IRA contribution limit of $6,000/$7,000, depending upon their age. This is a great vehicle for those earning more than the Roth contribution limits and/or the pre-tax traditional IRA contribution income limits.

There is a two-step process to doing a backdoor Roth IRA conversion:

First, make an after-tax contribution to an existing traditional IRA account.

Next, convert this amount to a Roth IRA. The amount of an IRA conversion is normally fully taxable in the year it occurs, except for any amount contributed on an after-tax basis. Assuming this contribution is the only money you have in a traditional IRA account, the conversion to a Roth will be tax-free. If there were any gains on the account, those gains would be taxed.

Backdoor IRA Complication

However, this strategy is not without it's complications if you have existing traditional IRA accounts that were funded with pre-tax contributions. In this case, the Roth conversion of post-tax money must be done on a pro-rated basis of the total of all IRAs. As an example:

Money in IRAs from pre-tax contributions $100,000
Current year after-tax contribution $6,500
Total $106,500

If you wanted to convert only the $6,500, then 6.1% or $397 would be eligible for a tax-free conversion to a Roth, with the rest being subject to taxes based upon your top marginal tax rate.

IRS rules don’t allow IRA account holders to convert only pre-tax IRA assets to avoid the tax.

Workaround Of Existing IRA Accounts

One potential workaround for those who have both pre-tax and post-tax IRA assets is to roll the pre-tax dollars to their current employer’s 401(k) or 403(b) plan. This depends if your employer's plan accepts this type of rollover and you will need to check with your plan’s administrator on this.

This process is called a reverse rollover. By rolling the pre-tax dollars to your current company’s 401(k) plan, you eliminate the issue of pro-rated taxation of future backdoor Roth conversions.

Those who are self-employed can also use this method with their solo 401(k) as well.

In the case of those who are employed by a company, the reverse rollover decision should involve more than a desire to convert $6,000 or $7,000 annually to a Roth IRA, though this is a desirable thing to do for most investors. The decision should also be made in the context of the quality of the plan and the investments offered by your current employer. It would be penny wise and pound foolish to roll this hard-earned money into a lousy plan just to be able to do a Roth conversion each year.

If your employer does not support a rollover option then the backdoor Roth IRA isn't an option for you.

What About a Roth 401(k)?

For those who earn too much to make a Roth IRA contribution, another alternative is to direct some or all of their salary deferrals to a Roth 401(k) option if their employer’s plan offers this alternative. Roth 401(k) contributions are limited to $19,500 for those under 50 or $26,000 for those who are 50 or over, and all of that can be directed to the Roth option. By law, any company matching dollars must be directed to a traditional, pre-tax 401(k) option.

For those who are self-employed, the Roth contributions can be an option if your custodian offers one.

Summary

For those who earn too much, the backdoor Roth IRA is a good vehicle to build up a balance in a Roth IRA account and reap the benefits.

Roger Wohlner

Roger Wohlner is an experienced financial advisor, finance blogger and freelance writer based in Arlington Heights, Ill. His expertise includes providing financial planning and investment advice to individual clients, 401(k) plan sponsors, foundations and endowments. Roger contributes to his own popular finance blog, The Chicago Financial Planner, where he writes about issues concerning financial planning, investments and retirement plans. His work has been featured on Investopedia, Go Banking Rates, US News & World Report, Yahoo! Finance, Equifax Finance Blog and other publications. You can follow Roger on: Twitter - LinkedIn

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