High-income individuals are shut out from contributing directly to a Roth IRA. But even if your income is more than the maximum allowed, there is a way to gain entry to this popular retirement savings account by employing a strategy called a “backdoor” Roth.
What makes Roth IRAs popular?
A Roth IRA is similar to a traditional individual retirement account, but you fund it with money that’s already been taxed—meaning there’s no upfront tax break. (In 2018, you can save up to $5,500 each year, or $6,500 if you are 50 or older, in an IRA account.) With a Roth, there is no tax on funds when you withdraw them in retirement. With a traditional IRA, you pay income taxes on funds you withdraw from the account. What’s more, Roth IRAs are not subject to required minimum distributions after the holder turns 70-and-a-half.
The hitch: To qualify for a full Roth contribution, you cannot make more than $189,000 if married and filing jointly (incomes of up to $199,000 can make a reduced contribution) or $120,000 if single (those making up to $135,000 can make a partial contribution).
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The backdoor Roth and taxes
While income caps keep some individuals from contributing to a Roth, there are zero income restrictions on converting from a traditional IRA to a Roth IRA. That means high-income investors can make regular IRA contributions and then convert them to a Roth.
Converting to a Roth isn’t without penalty: You must pay taxes on whatever contributions haven’t previously been taxed, under the Internal Revenue Service (IRS)’s pro rata rule. You must figure the ratio of IRA funds that have never been taxed (in other words, deductible IRA contributions and earnings) to the total assets in all of your IRAs.
Let’s say you have $94,500 in traditional IRA assets and make a nondeductible IRA contribution of $5,500 this year with the intention of converting it to a Roth IRA. In this case, 94.5% of your total of $100,000 in IRA assets has not yet been taxed. That means that 94.5% of your $5,500 contribution, or $5,197.50, would be taxable upon conversion. If you opted to convert your entire $100,000, you’d owe taxes on $94,500.
How to avoid the pro rata rule
There is a way to work around the pro rata rule too—with a reverse rollover. If your employer’s 401(k) plan allows you to roll IRA money into it, you can move your deductible IRA contributions and pre-tax earnings into the 401(k). This is a good move if your employer’s plan offers solid, low-cost investment options. Then you can convert any remaining, nondeductible contributions you have made to your traditional IRA into a Roth IRA. In this case, you’d owe no taxes on the conversion and would secure a tax-free stream of income in retirement when you begin making withdrawals.