How to Fund a Roth IRA When Your Income Exceeds the Limit
A “backdoor” Roth IRA is a strategy for contributing to a Roth IRA when your income exceeds the contribution limit. There is no income limit on contributing to a nondeductible Traditional IRA, nor on converting a Traditional IRA to a Roth IRA.
When making a “backdoor” Roth IRA contribution, a nondeductible contribution is being made, i.e., post-tax money to a Traditional IRA before making a Roth conversion. It’s important to consider any pre-existing (non-Roth) IRA funds in Traditional, SEP, and SIMPLE IRAs and old 401k’s which were likely all deductible contributions…this, plus the pre-tax earnings, will impact the conversion.
WHAT YOU NEED TO CONSIDER
When engaging a Roth conversion, one cannot limit the conversion to just the nondeductible contribution. All accounts are considered when converting. When filing income taxes, the money converted is representative of all money in all Traditional, SEP, and SIMPLE IRA accounts, as well as old 401k’s, regardless of which account the Roth conversion money comes from.
For example: If the nondeductible contribution is only 25% of all the money in Traditional, SEP, and SIMPLE IRA accounts, then only 25% of the Roth conversion amount will be tax-free. The remaining 75% of the Roth conversion amount will represent the deductible (pre-tax) money across all of the Traditional, SEP, and SIMPLE IRAs.
Consequently, tax will be owed (at current income tax rates) on 75% of the Roth conversion amount If you are eligible to transfer the pre-tax IRA funds to a solo 401k, employer-sponsored 401k, or 403b. If so, those amounts will not be subject to taxation during the Roth conversion process.
HOW TO MAKE A “BACKDOOR” CONTRIBUTION
To make a “backdoor” contribution, first, make a regular contribution to a Traditional IRA. It is not necessary to specify whether the IRA is deductible or not; it is just treated as an IRA. Once the contribution is made, convert to a Roth IRA. This is accomplished by selling the shares in your Traditional IRA and using the funds to open a new account in a Roth IRA.
Basically, it’s one additional signature. Being the initial contribution was non-deductible, you pay tax only on the difference between the converted value and the amount contributed. For all intents and purposes, you are essentially funding a Roth IRA.
When you have any other (non-Roth) IRAs, the taxable portion of any conversion made is prorated over all IRAs. Again, one cannot convert only the non-deductible amount. In order to benefit from the “backdoor”, you must either convert your other IRAs (which needs to be carefully considered being you are likely in a high tax bracket), or transfer the deductible IRA contributions to an employer plan such as a 401k.
HOW IT ALL WORKS
Here’s an example to illustrate the proration component. Suppose you contributed $5,000 to a new traditional IRA of non-deductible contributions. The plan is to convert this IRA to a Roth IRA via the “backdoor” strategy. Suppose you also have another traditional IRA with $15,000 in deductible pre-tax contributions. These contributions may have come from a 401(k) rollover, or from standard deductible traditional IRA contributions from earlier years when eligibility allowed making deductible contributions to a traditional IRA.
To compute the tax due, the formula is as follows: $5,000 divided by $20,000 (the total value of all traditional IRAs), equaling the percentage of the conversion that will be tax-free. In this case, it is 25%. Therefore, the other 75% of the conversion, $3,750, is taxable.
The moral of the story…clear out previously deductible contributions either by converting or transferring to existing employer sponsored retirement plan. Then, fund an IRA and convert annually to Roth to maximize your tax-free bucket of wealth.
If you would like to learn more about this subject or receive a free quote then please contact us and we’ll be happy to help.
*To qualify for the tax-free and penalty-free withdrawal of earnings, a Roth IRA must be in place for at least five tax years, and the distribution must take place after age 59 ½ or due to death, disability, or a first-time home purchase ($10,000 lifetime maximum). Depending on state law, Roth IRA distributions may be subject to state taxes.
Eligibility to contribute to a Roth IRA phases out a higher modified adjusted gross income level. IF ELIGIBLE, you can withdraw all or part of your Traditional IRA, and roll it over into a Roth IRA. You will owe taxes on the portion of the conversion that represents the earnings and the contributions distributed from the Traditional IRA that were not previously taxed. The amount you convert will be taxable in the year the rollover is made.
By Anthony C. Williams, CWS, ChFC, MRFC, CLU | Investment Advisor Representative | President & Founding Partner of Mosaic Financial Associates & Orthopaedist Advisory Group | Securities and advisory services offered through Cetera Advisors LLC, Member FINRA/SIPC, a broker/dealer and a Registered Investment Advisor. Cetera is under separate ownership from any other named entity.