How to Contribute to a Roth IRA Even if Your Income is Too High
Roth Individual Retirement Accounts (IRA) are attractive investment accounts because of the tax-free income that they provide with qualified withdrawals. However, many higher-income earners are not eligible to contribute to a Roth IRA.
Fortunately, there is a strategy to navigate around this – often referred to as the "Backdoor Roth IRA". The process involves opening a traditional IRA, making your desired contribution - up to the annual maximum amount, and then later convert the funds to a Roth IRA.
This strategy has gained popularity with higher-income earners…Could it really be this easy? The IRS hasn’t weighed-in definitively on what’s allowed, so it’s helpful to understand some of the issues. It’s also highly recommended that you work with a professional accountant or tax advisor.
The Appeal and Limitations of a Roth
Unlike traditional IRA's, 401(k) retirement plans, and other tax-deferred accounts that receive up-front tax deductions on contributions, Roth IRA do not.
However, you will not need to pay income tax on either principal or earnings when you withdraw your money, as long as you are at least age 59½ and have had the Roth IRA for five years. Also, there are no Required Minimum Distributions (RMD) or time requirement on when you have to withdraw money. This can be appealing strategy to individuals that want to leave a legacy and pass money-on tax-free to their heirs.
The trouble is that Roth IRAs technically are only available to those whose annual income is below certain levels. In 2020 those limits are based on Modified Adjusted Gross Income (MAGI)* of:
· $196,000 - $206,000 for Married couples filing jointly
· $124,000 - $139,000 for Single and Head of Household filers
*The eligible contribution amounts are reduced when the lower thresholds are reached, and completely phased-out once the upper limits are reached.
A Two-Step Roth Conversion Process
In 2010, Congress passed rules to provide more flexibility and allow retirement savers to convert savings held in a traditional IRA into a Roth IRA, paying taxes on the distributions when they make the conversion. Some higher-income earners use this approach, in a two-step process:
Open a non-deductible traditional IRA and make after-tax contributions. For 2020, you’re allowed to contribute up to $6,000 ($7,000 if you’re age 50 or older). Make sure you file IRS Form 8606 every year you do this to track and report your cost basis.
Transfer the assets from the traditional IRA to a Roth IRA. You can make this transfer and conversion at any point in the future. It's suggested that you wait a few months to do this.
Pay the Taxes
The conversion will trigger income tax on the growth above the after-tax contributions—but once in the Roth IRA, future earnings will grow tax-free. Distributions from the Roth IRA in the future will also be tax-free as long as you are age 59½ and have held the Roth IRA for at least five years (note: each conversion is subject to its own five-year holding period as it relates to tax-free withdrawals).
Calculating your taxable amount is simple if you do not have any other IRAs. However, this gets more complicated if you have other IRAs. The IRS does not allow you to cherry pick and choose which specific dollars get to be converted. The "pro-rata" rule requires you to aggregate all of your IRA assets together when calculating the taxable portion.
All IRAs funded with pretax (deductible) contributions as well as those funded with after-tax (nondeductible) contributions must first be added together. The percentage of pretax (deductible) amount divided by the total is the proportional amount of taxes that needs to be paid on the converted amount.
It's kind of like when you add cream to your coffee. Each sip you take is a mixture of coffee - with some cream. You cannot separate them once they are mixed together.
Eg. James makes a $6,000 contribution to a nondeductible traditional IRA. He also has a rollover IRA worth $94,000 from a previous 401(k) made with pretax contributions.
Total value of both accounts = $100,000
Pretax contributions = $94,000
After-tax contribution: $6,000
$6,000 / $100,000 = 6%
$6,000 (the amount converted) x 6% = $360 tax-free
$6,000 - $360 = $5,640 subject to income tax
Note: If your 401(k) allows you to “roll in” an IRA account, as some do, you can essentially take your existing IRA out of the conversion calculation.
The Backdoor Roth May Not Survive Forever
This strategy has existed since 2010 but the IRS has not provided guidance on whether it violates the step-transaction doctrine (a series of transactions designed and executed as parts that will be treated as a single transaction for tax purposes). Tax professionals have mixed opinions on the likelihood of this happening, but the lack of a definitive ruling means that there is some risk involved. If the IRS decides that the loophole is a violation, you could owe a 6% excise tax for overfunding your Roth IRA. Allowing time to pass between the contribution and subsequent conversions can help avoid the step-transaction rule, but there is some debate about just how much time must pass.
If restrictions do come into play at some point, they could require a taxpayer to pay a penalty - or they might provide a grandfather clause. This is something to take into consideration before proceeding.
Roth conversions generally make sense for high-income investors with large amounts accumulated in traditional IRA or retirement accounts. Diversifying the taxation of your future retirement income provides flexibility on your withdrawal strategy and can help mitigate future taxes paid.
Reach out today to discuss your particular situation in more detail. Every case is very subjective to each individual and household's financial situation.
