If you have already maxed out 401(k) contributions and earn an income that exceeds the traditional IRA tax deduction and Roth contribution limits, it is common to think that all tax advantaged options have been exhausted. Some investors are not aware that there is a Roth IRA option for high income earners. It is referred to as the backdoor Roth IRA. The backdoor Roth IRA is made possible by a tax loophole that gives high income earners the ability to capitalize on the tax advantages offered through the Roth IRA.
Backdoor Roth IRA
As a single-filer who makes more than $131,000 (for 2015), it would seem that you are out of tax-advantaged luck beyond your employer sponsored plan. However, in 2010 a change was made to the tax code to remove the income limit for Roth IRA conversions, establishing a loophole for high income earners (those above IRS limits). As a result, a creative use of Roth conversions presented itself. Simply contribute to a non-deductible traditional IRA and then complete a Roth conversion immediately thereafter. It is a two-step process that allows high earners to access the benefits of the Roth IRA, despite the income limitations.
Backdoor Roth vs. Roth Conversion
You might have read about converting a traditional IRA into a Roth IRA. In a straightforward Roth conversion, an existing IRA balance can be converted into a Roth IRA. The taxpayer is responsible for paying ordinary income tax on the amount that is converted.
With a backdoor Roth IRA and diligent planning, it is possible to avoid a large tax responsibility because the contribution to the traditional IRA is non-deductible. There is an exception to this rule. If the non-deductible traditional IRA earns any interest, dividends, or capital gains before it is converted to a Roth IRA, taxes are due on those earnings.
When considering a backdoor Roth IRA, pay close attention to the pro-rata rule. When it comes to taxes, nothing is easy. This is especially true when taking advantage of a tax loophole. In a nutshell, the pro-rata rule states that any withdrawals taken from IRAs must be equally divided between taxable and non-taxable funds. Under the pro-rata rule, ALL IRA holdings will affect the tax consequences of using a backdoor Roth.
- You have $45,000 in a rollover IRA from a previous employer-sponsored retirement plan.
- Then you put $5,000 in a new nondeductible IRA.
- You have a ratio of 10:1 of taxable to non-taxable money.
- When you convert the $5,000 nondeductible IRA to a Roth, you will actually owe taxes on $4,500. That’s because 90 percent of your available IRA funds has never been taxed.
If you have sizable funds in IRAs, whether traditional IRAs, rollover IRAs, or SEPs, the pro-rata rule could create a large tax burden for the conversion year or completely eliminate the benefit of the strategy. If you think the pro rata rule will affect you, seek the advice of your advisor before converting. The backdoor Roth IRA is certainly not for everyone, but for some high income earners, it can be a great way to gain access to an additional tax-advantaged retirement strategy and boost your nest egg.
Interested in learning more? Check out this article written by Andrea L. Blackwelder, CFP®, ChFC for the publication Retirement Weekly, titled “Should you Consider a Roth Conversion?”
Image courtesy of Stuart Miles at FreeDigitalPhotos.net