Even if you exceed the income limits for contributing to a Roth IRA, you may still be able to take advantage of this excellent additional retirement account option. You can work through what’s called a “backdoor Roth,” which basically means that you convert traditional IRA contributions into a Roth IRA.
The process gets a little complicated, and it's not always the best option, but it can be helpful in some situations. I'll walk through the basics here. If you are considering a backdoor Roth IRA, however, you should definitely consult with a retirement account specialist.
How a Backdoor Roth Works
Though the IRS places an income limit on contributing directly to a Roth IRA, there's no income limit on converting a Traditional IRA to a Roth IRA. A backdoor Roth takes advantage of this fact by contributing to a Traditional IRAwith the intention of immediately converting the contribution.
Basically, you'll make a regular, non-deductible contribution to a Traditional IRA through your IRA custodian. Right after the contribution posts, you'll convert it to a Roth IRA. How the conversion works will depend on your custodian but you might, for instance, buy shares in a Roth IRA and "sell" shares of your Traditional IRA to fund it.
Because your initial contribution was already non-deductible, you'll have essentially already paid taxes on it. So you'll only need to pay extra taxes on the difference between the converted value and the amount contributed. Since the money was in your account for such a small amount of time the tax is usually minimal.
If you already have a Roth IRA, your administrator will just put the amount into that account. If you don't, you'll open a new Roth IRA to complete this transaction.
A Potential Problem
One potential problem with this transaction is the IRA pro-rata rule. Basically, you're not allowed to earmark only non-deductible contributions for a conversion. So if you have existing pre-tax IRAs, you'll be forced to convert some of your deductible contributions as well.
Say, for instance, that you have $90,000 in Traditional IRA assets, which came from deductible contributions. Then you put in $10,000 as a non-deductible contribution with the intention to roll it into a Roth IRA.
But when you do a conversion, you can’t convert just the $10,000 non-deductible contribution. You’ll actually have to roll over a total of 10% of your Traditional IRA assets, spread evenly across deductible and non-deductible contributions. So you’ll actually roll over $9,000 of deductible contributions and $1,000 of non-deductible contributions.
To get around this in the future, you'll need to either roll all your Traditional IRAs over to a Roth account, or roll your Traditional IRAs to an employer-sponsored 401(k). The first option can cost you a lot in taxes (especially since you're already in a high tax bracket), and the second could cost you earnings if your 401(k) doesn't have great investment options.
Doing the Math
If you do have other Traditional IRA assets, you’ll definitely want to do the math to figure out whether or not using a backdoor Roth is worth your while. According to this Bogleheads article, the formula you’ll use is this:
TF = 100 x [C/(C+B)]
- TF = The percentage of the amount you're converting that would be tax-free
- C = Amount to convert to Roth
- B = Balance of all pre-tax IRAs
If, for example, you have a total of $50,000 in pre-tax IRAs and make a $5,000 contribution that you'd like to roll over to a Roth, you'd calculate your taxable portion like this:
TF = 100 x [5,000/(5,000 + 50,000)]
TF = 9%
So you'd have to pay taxes on 91% of your converted amount, or $4,550.
When it Works Best
As you can see, using a backdoor Roth isn’t as complicated as you might think. And in spite of its somewhat subversive name, it’s a completely legal and even standard investing practice for high-income earners.
But that doesn't necessarily mean that a backdoor Roth will work best for you. Here's when you might try it:
- If you don't have other pre-tax IRAs to worry about, then a backdoor Roth won't cost you much at all in taxes, making it an ideal option.
- If you can roll your pre-tax IRA into your employer's plan without losing valuable investment options, then you benefit from a backdoor Roth (but only after those assets are converted).
- If you're self-employed and newly starting a Solo-401(k) into which you can roll your pre-tax IRA assets, then using a backdoor Roth for additional retirement savings could be helpful.
As with any complex retirement move, it’s a good idea to consult with a tax professional before you attempt to actually use the backdoor Roth method. But now you know that investing in a Roth IRA is, indeed, an option, even if you’re over the IRS’s income limits.