The Backdoor Roth IRA for High Income Earners: A Step-by-Step How To Guide

Door

Greetings.

I normally contribute to Roth IRA lump sum of $5K for previous year before April 15th of this year. While filling taxes (married jointly) for 2012, I realized that my wife’s and mine combined salary is at $185K which is above the limit of $183K. Could you please advise on what options I have to invest in Roth IRA. I have been doing this diligently for last 5 years and so far my returns have been at 47%. I really don’t want to miss out on the contribution.

Thanks!

Abhay K.

Hi Abhay,

Thanks for your question.   You are correct that your income exceeds the Roth limit.  The limit for single filers is $127k (phase out starts at $112k) and for married filers is $188k (phase out starts at $178k).  See the full Roth contribution Income Limits Table.

The Backdoor Roth IRA

Despite exceeding the limit, you can still contribute to a Roth IRA due to a loophole.  High earners cannot contribute directly to a Roth IRA, but they can contribute to a Traditional IRA and they can convert a Traditional to a Roth, which accomplishes the same thing as opening a Roth directly.

 

Traditional contribution + Traditional-to-Roth Conversion = Roth (Backdoor) Contribution

 

It may seem like a hassle, but it actually only takes a few minutes and the tax savings over the years can really add up.  Here’s the step by step process.

Step 1.  Contribute to a Traditional IRA (non-deductible)

  • Open a Traditional IRA (suggested account providers)
  • Contribute up to the contribution limit ($5,500 this year for those under 50)
  • Your contribution will probably not be tax deductible (However, Roth IRA contributions are not tax deductible)
  • This creates a “cost basis” of the contributed amount

Step 2.  Convert your Traditional IRA to a Roth IRA

  • There used to be income limits blocking high earners from doing these conversions, but the limits expired in 2010.  Now anyone can convert.

Step 3.  Pay any taxes on the conversion (probably close to zero)

  • Converting from Traditional to Roth is a taxable event
  • Since you already paid taxes on the money contributed (it wasn’t deductible), you now only owe taxes on any gains that you earned before the conversion
  • Taxes Owed = Tax Rate x (Conversion Value – Contribution Value)
  • If Conversion Value = Contribution Value, Taxes Owed = ZERO

Result:

  • Full contribution amount in a Roth IRA using post-tax dollars

An example:

  • Amy and her spouse earn $200k per year, making her ineligible to contribute to a Roth IRA
  • Amy contributes $5,500 to a Traditional IRA
  • The contribution is NOT tax-deductible because of her high income
  • The “cost basis” on her investment is $5,500
  • Amy contacts her IRA administrator (i.e. TD Ameritrade, E*trade, etc.) and tells them she wants to “convert” her Traditional IRA to a Roth IRA
  • In the few days between contribution to the Traditional IRA and converting to a Roth IRA, Amy’s account value has grown to $5,525.
  • Amy owes taxes on the $25 gain ($5,525 account value at conversion minus $5,500 cost basis).
  • Amy reports the $25 taxable gain on her taxes the following April.
  • Since Amy already had a Roth IRA with this IRA administrator, her “converted” amount was simply put into her existing Roth IRA.  If she hadn’t already had a Roth IRA, a new account would have been opened during the conversion process.

The Pro-Rata Rule

All rollovers from Traditional to Roth IRAs must be done on a pro-rata basis.  So if you have existing Traditional assets (pre-tax) and you try to do a Backdoor Roth IRA by contributing to a non-deductible Traditional IRA (post-tax), you cannot choose to only rollover the non-deductible Traditional assets.  Instead, any amount you rollover will be taken proportionally from across all of your Traditional assets.  For example, if you have $90k in deductible contributions and you make $10k in non-deductible contributions, intending to immediately roll it over to a Roth, when you do the $10k Traditional to Roth conversion (10% of your total Traditional assets) you will actually be converting $9k from your deductible contributions (10% of $90k) and $1k from your non-deductible contributions (10% of $10k).

Learn more about the pros and cons of various IRA contribution options for high income earners.

Choosing the Right Roth IRA

Before you open an account, be sure to think carefully about how you plan to invest.  If you are a long-term passive mutual fund investor, choose an account like Scottrade with 3,000+ no transaction fee funds and super low expense ratios on index funds (as low as 0.095%).  If you prefer to trade stocks in your Roth IRA, look for an account with easy access to company research and analysis software, like TD Ameritrade.  Learn more about Roth IRA account options here.

Other Articles by Joanna on Backdoor Roth IRA Conversions and the Pro Rate Rule:

 

About the Author

Joanna D. Pratt, CFA is an experienced institutional investor.  She holds a bachelor’s degree in economics and certificate in finance from Princeton and an MBA from Stanford.

Have a question about investing or retirement? Ask An Advisor here.

 

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