The Sneaky Way for High Earners to Add Money into a Roth IRA Tax-Free
When you are thinking about how to put your hard-earned dollars to work, it’s important to consider every option for savings. Making a backdoor Roth IRA contribution is a way for people with high incomes to sidestep the Roth’s income limits. That’s good news, because your money grows tax-free and withdrawals are also tax-free once you meet certain requirements. Having a sizable tax-free asset is a pretty nice perk to have when it comes time to take your money out in retirement.
Who should be doing this?
If you are already maxing out your contributions to your employer’s retirement plan, are not eligible to make a direct Roth IRA contribution or don’t have a Roth option through your employer’s retirement plan, this is a great way to build up a tax-free asset. For single taxpayers, once your modified adjusted gross income is $137,000 or more ($203,000 for married couples), you cannot contribute directly to a Roth IRA.
How a Backdoor Roth IRA Contribution Works
If you are not familiar with the Backdoor Roth IRA contribution, it is basically a three-step process:
- Make a contribution to a traditional IRA. You can contribute up to $6,000 per year, or if you are age 50 or over, you can add $7,000. You can also contribute to a separate IRA for a spouse even if they are not working. For single taxpayers, if your modified adjusted gross income is $74,000 or more, the contribution is non-deductible. For married couples, the limit is $123,000 or $203,000, depending on if one or both spouses are covered by an employer’s retirement plan.
- Make a Roth conversion of the traditional IRA you just established by moving the money from the traditional IRA to the Roth IRA. A Roth conversion is a taxable event, but if the initial IRA contribution was non-deductible, it’s tax-free since that money has already been taxed.
- Make sure the contribution is reported correctly when you file your taxes on form 8606. In all you will receive three tax forms at the beginning of the year following the contribution and conversion:
- Tax Form 5498 showing initial contribution into the IRA
- 1099-R showing the distribution out of the IRA
- Tax Form 5498 showing the conversion into the Roth IRA
Both amateur and professional tax preparers frequently make errors on Form 8606 or fail to file it at all so it’s key to double-check that it was reported correctly so you don’t trigger an unnecessary tax bill.
Is this legal?
The IRS clarified in early 2018 that no waiting period is required between the contribution and conversion steps of the Backdoor Roth IRA, essentially giving its blessing on the whole process.
Beware of the IRA aggregation rule!
This strategy only works if you don’t have any money in any traditional IRA, SIMPLE or SEP accounts on December 31 of the year you make the conversion. The IRA aggregation rule states that when an individual has multiple IRAs, they will all be treated as one account when determining the tax consequences of any distributions (including a distribution out of the account for a Roth conversion).
Example: John has $100,000 in an IRA from an old 401(k) plan that was rolled over. He now wants to make a $6,000 contribution to a non-deductible IRA, with the plan to convert that amount into a Roth IRA. However, due to the IRA aggregation rule, he cannot just convert the $6,000 non-deductible IRA contribution, even if it is held in a separate account. Instead, John must treat the conversion from any account as a partial conversion of all of his IRA assets so he will owe some taxes on almost all of the converted amount. Assuming John’s in the 32% federal tax bracket in 2019, he will owe $1,816 in federal taxes.
Employer retirement plans are not counted in the IRA aggregation rule, which means you can roll any existing IRA accounts into a 401(k), 403(b), or Individual 401(k) to avoid this issue.
What if I need this money?
If the traditional IRA contribution was non-deductible you can withdraw the amount converted to the Roth IRA at any time free of any penalties or taxes (any earnings withdrawn will be taxed as income plus a 10% penalty unless one of the exceptions applies). Once you reach age 59 ½ and five tax years elapsed from the Roth conversion, earnings can be withdrawn penalty- and tax-free. Note that each conversion has its own five-year waiting period before earnings can be withdrawn tax-free.
My employer’s retirement plan has a Roth option so shouldn’t I just add money there?
With a Roth 401(k) or 403(b) contribution, you’re trying to decide which is better — tax-deferred or tax-free. For high earners, the Roth may not make sense since you are taxed on your contributions. Using the previous example, if John contributed the maximum of $19,000 to his Roth 401(k) instead of the pre-tax 401(k) for 2019, this would increase his tax bill by $6,080. Since the current tax brackets are set to expire and increase after 2025, it may make sense to pay taxes today to lock in the current lower rates, although you will need to make sure to have money to cover the tax bill.
The backdoor Roth IRA strategy is really meant to be used once you are already maxing out your retirement plan. For high earners, you are choosing between putting an additional $6,000 in an account that taxes withdrawals with no upfront tax benefit (non-deductible traditional IRA) versus a tax-free account (Roth IRA). Seems like a no brainer to put it into the Roth IRA!
An important lesson here is that tax diversification is useful. Higher taxes seems to be unavoidable at some point in the future with the rising budget deficit and to keep programs like Social Security and Medicare afloat. Having some money in a vehicle like a Roth IRA that is tax-free gives you a great deal of flexibility to manage your tax situation in retirement.
Armstrong, Fleming & Moore, Inc. does not provide legal or tax advice. You should consult a legal or tax professional regarding your individual situation.
Presented by Carl Holubowich, CFP®