Earn too much to contribute to a Roth IRA?
Roth IRAs are a terrific retirement account although not everyone is able to contribute directly to them because of income limits. There is a solution for people who fall into this category that give them all of them benefits of a Roth IRA even if they earn too much. This solution is called a Backdoor Roth IRA.
A Backdoor Roth allows you to contribute because of a loophole. If you are a high earner, you can contribute to a Traditional IRA and then convert the Traditional to a Roth. This is not a complicated process and is a smart way to gain access to a Roth IRA.
There are 3 steps to a Backdoor Roth IRA:
Step 1: Contribute to a Traditional IRA.
You will need to open a Traditional IRA account and make your contribution. You can contribute $5,500 if you are under 50 and $6,500 if you are over 50. This amount is likely not deductible but a Roth contribution is not either.
Step 2: Convert your Traditional IRA to a Roth IRA.
You will need to open or use an existing Roth IRA. Your advisor, brokerage firm or mutual fund company will have a form for you to complete this step.
Step 3: Pay taxes (if any) on the conversion amount.
The process of converting a Traditional to a Roth is a taxable event. If your Traditional contribution was nondeductible it is an after tax event. You will only have to pay taxes on the gains in your account. If you complete your conversion soon after contributing to your Traditional your taxes will be minimal. In fact, if your conversion amount to equal to your contribution amount you won’t owe anything for the conversion.
If you already have a Traditional IRA, there is a catch to this plan. All rollovers or conversions from a Traditional to a Roth must be done on a pro rata basis. Your existing Traditional assets are likely pre tax and you are not allowed to select which money is converted to the Roth. For example, if you have $45,000 in deductible contributions and want to contribute $5,000 in non-deductible contributions to rollover immediately into a Roth you won’t be able to do that. $4,500 will come from your deductible contribution and only $500 will come from your nondeductible. Your tax bill will be higher as well. Consult a tax professional or investment advisor for help with this calculation.
Bill and Susan earn $225,000 as a couple and are 45 years old. Susan contributes $5,500 to a Traditional IRA and invests in a large cap stock mutual fund. The contribution is not tax deductible because of the couple’s high income. Susan informs her advisor that she wants to convert her Traditional to a Roth. During the time between when she made her contribution and the conversion, her account rose 3% to $5,665. Susan will owe taxes on the $165 gain and report that on her taxes for the year she did the conversion. Now Susan has a Roth IRA.
This is a great solution for those who don’t meet the standard requirements to contribute to a Roth IRA.