If you are a successful entrepreneur, you are probably (hopefully!) already contributing to a 401(k) plan. For the 2016 tax year, the 401(k) salary deferral limit for participants under age 50 is $18,000. While your deferrals may be allocated to traditional (pre-tax) 401(k) and/or after-tax Roth 401(k) accounts, if you are in a high marginal federal income tax bracket, you likely favor traditional 401(k) contributions.
At the same time, you may have also heard or read about the merits of having both tax-deferred and tax-free Roth savings to draw from in retirement. You might like to be able to make an additional contribution to a self-directed Roth IRA, but, unfortunately (or fortunately, depending on how you look at it) your income is above the IRS eligibility limits [see Table 1]. So you are out of luck, right? Not necessarily.
Table 1. Amount of Roth IRA Contributions That You Can Make for 2016
This table shows whether your contribution eligibility to a Roth IRA is affected by the amount of your MAGI (modified adjusted gross income) as computed for Roth IRA purposes. [Source: IRS Publication 590]
If your filing status is… |
And your modified AGI is… |
Then you can contribute… |
|---|---|---|
|
Married filing jointly or qualifying widow(er) |
< $184,000 |
up to the limit |
|
> $184,000 but < $194,000 |
a reduced amount |
|
|
> $194,000 |
zero |
|
|
Single, head of household, or married filing separately and you did not live with your spouse at any time during the year |
< $117,000 |
up to the limit |
|
> $117,000 but < $132,000 |
a reduced amount |
|
|
> $132,000 |
zero |
More Than You Wanted to Know About the Internal Revenue Code
With an assist from some relatively arcane IRS rules, you may still be able to get money into a Roth IRA, even if your income exceeds the eligibility caps in the table above. This opportunity arose serendipitously from the repeal of the income limits on conversions from traditional IRAs to Roth IRAs beginning in 2010.
Congress’ motivation in relaxing the conversion rules was presumably to generate tax revenue by encouraging high-earning workers to convert retirement savings to Roth IRAs at high marginal tax rates. In doing so, however, Congress also unwittingly opened a loophole that, in certain circumstances, may permit higher earning taxpayers to convert traditional IRA money to Roth IRAs without paying federal income tax on the conversion.
This strategy, which has become known as a “backdoor Roth conversion,” involves a two-step process:
- The first step entails making a $5,500 non-deductible contribution to a traditional IRA and documenting the deposit on IRS Form 8606).
- Once the contribution has been made, the taxpayer then processes the conversion of the after-tax Traditional IRA contributions to a Roth IRA, and, “Voila!” you have managed to sneak $5,500 through the backdoor into your Roth IRA!
Beware the Pro-Rata Rule
While the opportunity to circumvent the Roth IRA income eligibility limits may be appealing, taxpayers should be aware that a backdoor Roth conversion may only be tax free if the person effecting the conversion does not have any other pre-tax traditional IRA money (including funds from rollover IRAs). If the taxpayer does have other pre-tax IRA money, the conversion may be subject to pro-rata taxation.
A potential workaround solution for this may be to transfer all other traditional IRA funds except he non-deductible IRA contributions to either the taxpayer’s 401(k) or their other employer-sponsored retirement account, as assets in these accounts are not considered in the pro-rata tax.
Taxpayers should also be aware that slightly different rules apply to conversions vs. contributions. For more on this, see the following article link – Understanding The Two 5-Year Rules For Roth IRA Contributions And Conversions (Nerd’s Eye View)
Summary
The backdoor conversion strategy may offer a neat way for investors who are not otherwise eligible to fund Roth IRAs. If implemented over a period of years, it may enable taxpayers to build a significant stash of tax free retirement savings. The effects of this strategy may be enhanced even more for married couples if it’s executed by both spouses. Per above, taxpayers considering this strategy should be aware that the conversion may only be tax free in the absence of other pre-tax IRA money.
While this article is intended to raise awareness of an interesting retirement savings strategy, it in no way constitutes specific tax advice. Given the complexities of the rules involved, it is strongly recommended that readers consult with their CPAs or other tax, legal, or financial professionals before pushing ahead with a backdoor Roth conversion.
Related Reading:
Spending from a Portfolio: Implications of Withdrawal Order for Taxable Investors (Vanguard)
Making a “backdoor” Roth IRA contribution (Journal of Accountancy)
The IRA Aggregation Rule And Pro-Rata Taxation Of After-Tax IRA Dollars (Nerd’s Eye View)
I’m Over the Contribution Income Limit – Can I Still Get Money Into a Roth IRA? (Ed Slott)
