The High Earners Secret to Getting Money Into a Roth IRA
As young professionals advance in their careers they become intimately familiar with the downfalls of making more money. Certainly there’s no feeling sorry for those young professionals who are seeing their salaries grow, however, as income increases it often means the loss of a number of tax benefits as the IRS phases out certain deductions and credits at various income levels.
This common pitfall to an increasing salary is especially common when it comes to taking advantage of arguably the best retirement savings vehicles out there: the Roth IRA. Thankfully, there is a strategy that can help young professionals stash tax-free money away for retirement even if they make too much money.
Enter the “Backdoor Roth IRA.”
Setting the Stage for the Backdoor Roth IRA
Before jumping into the backdoor Roth strategy, it’s important to lay the basic groundwork. First, it’s important to fully understand the difference between a Traditional IRA and a Roth IRA. A traditional IRA allows individuals to save money for retirement using pre-tax dollars. In short, this simply means that an individual can contribute money into a retirement savings vehicle before paying taxes on the money; it’s then taxable upon withdrawal.
A Roth IRA, on the other hand, is similar to a Traditional IRA, in that you can only contribute $5,500 per year. However, a Roth IRA allows individuals to make after-tax contributions and, more importantly, it allows individuals to withdraw money tax-free in retirement. With a Roth IRA, you pay tax now so that you can withdraw money tax-free later.
Lastly, it’s important to understand that both the Traditional IRA and Roth IRA have income phase-out limits that qualify who can contribute to these retirement savings vehicles. These contribution limits are also an essential aspect of determining who should take advantage of the backdoor Roth strategy.
For Singles:
- Roth IRA contributions are phased out at $117,000 – $132,000
- Traditional IRA contributions (tax-deductible) are phased out at $61,000 – $71,000
For Couples (Married Filing Jointly):
- Roth IRA contributions are phased out at $184,000 – $194,000
- Traditional IRA contributions (tax-deductible) are phased out at $98,000 – $118,000 for individuals that have access to an employer sponsor retirement plan
- Traditional IRA contributions (tax-deductible) are phased out at $183,000 – $193,000 for individuals whose spouse has access to an employer sponsored retirement plan
Step by Step Guide to the Backdoor Roth IRA
Ultimately, the backdoor Roth IRA strategy is primarily relevant for those young professionals whose income falls above the phase-out limits. For those not eligible to make Roth IRA contributions and who do not have access to a Roth 401(k) (or they’ve already maxed it out) then utilizing the Backdoor Roth strategy to save additional money into a tax-free retirement account is likely your only option.
- Open a traditional IRA through an online brokerage platform, with your advisor, or at your bank. You can also get started with Lifewise.
- Then make a non-deductible Traditional IRA contribution to your newly opened Traditional IRA. Regardless of your income level you can always make non-deductible Traditional IRA contributions, but keep in mind you are still limited to the $5,500 annual limit.
- The IRS allows individuals to convert their Traditional IRA to a Roth IRA at any time. However, any traditional IRA money converted, is considered taxable income in that year because, again, it was pre-tax money to begin with. This means that any money converted is taxed as ordinary income in the year of conversion. Conversely, when you convert non-deductible contributions, only the portion converted attributable to growth is taxed, which if you do the conversion shortly after making the contribution should be nearly zero. This means you’ll be able to convert the contributions entirely tax-free and pay virtually no tax on the earnings.
Be Careful of Existing IRA Accounts
First, it’s important to understand that the IRS looks at all of your IRAs when you do a conversion, which can be a non-starter if you have multiple Traditional IRA accounts and here’s why: if you’ve made deductible contributions to an IRA or rolled over an old 401(k) into a Traditional IRA, the IRS will look at those dollars cumulatively as part of the conversion, even if you are only converting the non-deductible contributions.
Let’s say you have a $20,000 Traditional IRA that you’ve accumulated making deductible contributions prior to your income phasing you out of being able to make those deductible contributions. Now you find yourself unable to take advantage of the Roth IRA and your employer doesn’t offer a Roth 401(k) option, so you’re stuck accumulating money tax-deferred into your employer sponsored 401(k) plan.
You decide to make a $5,000 non-deductible contribution to a Traditional IRA and then plan to convert it into a Roth IRA.
The IRS requires you to total up all of your IRA money, which in this case is $25,000 of which 80% of the money is made up of deductible contributions and 20% is made up of non-deductible contributions. If you, the young professional and owner of these accounts, executed the backdoor Roth strategy on the $5,000 non-deductible IRA contributions, you’d end up paying tax on 80% of the $5,000 converted and receiving only tax-free benefits on 20% of the dollars.
As you can see, if you have other Traditional IRA money the backdoor Roth strategy can get complicated quickly and in many cases lose most of the benefits. All is not lost though. If you have an employer sponsored retirement plan, such as a 401(k), you can sometimes roll your existing IRAs into the plan, which would eliminate the accounts for purposes of the conversion. This can be a nice work around to alleviate the tax issues that arise during a conversion.
Be Wary of the Step Transaction Doctrine
The last consideration when it comes to the backdoor Roth strategy is the timing of contributions and ultimately the conversion. There is a strong debate surrounding how quickly individuals should execute the conversion of non-deductible dollars into the Roth IRA because of a little known IRS rule called the Step Transaction Doctrine.
Essentially, the Step Transaction Doctrine states that even if each individual step is legal and compliant with IRS rules, the end result of those steps can still be deemed illegal if the result is not aligned with the IRS’ intended purpose of the rules. In short, the step transaction doctrine is a catchall for the IRS.
The good news is that while the IRS can in theory argue that a backdoor Roth strategy is not compliant with IRS code, there is no history to prove that that is the case and the IRS has provided no indications that they in fact hold this view.
While each individual circumstance is unique and it largely comes down to an individual’s threshold for risk, it’s oftentimes best to wait one quarter before converting to be safe. For those who are ultra-conservative, the general consensus on that side of the aisle is to wait six months to convert. And for those who don’t anticipate any issues, then converting within days is not out of the question.
Read more: Want to learn everything there is to know about the backdoor Roth strategy? Check out this in-depth overview by industry leader, Michael Kitces.
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