- Tax-free distributions in retirement.
- Access to your contributions at any time penalty free.
- No required distributions at age 70 ½.
What’s not to like?
Well for one, if you make too much money, you may not be able to participate in a Roth IRA. For taxpayers who file as “single” or “married filing jointly,” you are ineligible to contribute to a Roth IRA if your adjusted gross income (AGI) in 2017 is above $133,000 and $196,000, respectively.
So end of story, right? Not exactly.
While income limits may prevent you from contributing directly to a Roth IRA, there is an IRS loophole that allows you to participate via a three-step process. This process is known as a “Backdoor Roth IRA.” The history of this strategy dates to 2010, when Congress removed income limits on Roth conversions while keeping income limits on Roth contributions intact. A conversion allows savers to take money from another tax-deferred vehicle (typically a traditional IRA or 401(k)) then convert the funds into a Roth, and pay tax on the amount rolled over. Since anyone can now convert to a Roth regardless of income, the door has been opened for some creative tax planning.
The Backdoor Roth Contribution
The mechanics of a Backdoor Roth are pretty simple. Here is an example outlining the details:
Dennis is 59 and his wife Patty is 58. They file their taxes “married filing jointly,” and their adjusted gross income in 2017 is $200,000, which is mostly earnings from Dennis’s job. Given their income level, Dennis and Patty earn too much to contribute to a Roth IRA and neither one of their employers offers a Roth 401(k) option. Is there a way they can still get money into a Roth IRA? Yes! Here’s how:
- Dennis and Patty will each open a traditional IRA in their own name and make a non-deductible contribution up to the limit allowed– $5,500 plus an additional $1,000 catch-up contribution since both are over 50.
- Simultaneously, Dennis and Patty will each open up a Roth IRA in their own name.
- Once the non-deductible contribution is posted to the traditional IRA, they will then convert the funds to the newly opened Roth IRA shortly thereafter.
Dennis and Patty will only owe tax on the conversion if there is any growth on the funds contributed–which if held in cash will be virtually nothing. Therefore, they’ve effectively contributed $13,000 to Roth IRAs without tripping the income limits!
While this Backdoor Roth strategy is extremely appealing for high-net-worth individuals, it doesn’t come without caveats. Here are some things to consider before taking the leap:
- If you have any assets in existing IRAs, this strategy may not be a good fit. That’s because of the pro-rata rule, which essentially requires individuals to pay tax on a ratio of ALL IRA assets they have when performing a conversion. This requirement could outweigh any potential benefit from the Backdoor Roth.
- If you’re not currently earning an income (unless you are a spouse of an earner), you’ll be unable to contribute to any type of IRA. Sorry retirees.
- If your current employer offers a Roth 401(k) option, that vehicle may be something to consider first since 401(k)’s are not subject to the income limits noted above. However, if you are maxing out your 401(k) and have extra cash, you can still do a Backdoor Roth in addition since contributions to these accounts are mutually exclusive. Just remember that funds invested in Roth 401(k)s are still subject to required minimum distributions at age 70 ½. So be sure to roll those funds over to a Roth IRA before you reach that age.
- The IRS is well aware of the Backdoor Roth loophole. It’s been open for almost 6 years now, but laws do change from time to time. Make sure you are up to date on current tax law before going forward and consult your tax advisor.
The Backdoor Roth can be a great tool for higher income earners to stash more funds away that will ultimately be tax-free. If you think this is something that may fit your situation, please feel free to reach out to me and I’d be happy to discuss the details with you.