Income Too High for a Roth IRA? Try sneaking in the backdoor

Sneaking in the Backdoor to a Roth IRA

Hi Joanna,

I do not qualify for a traditional IRA tax deduction because my employer offers a retirement plan and I make more than $69,000.

Should I still contribute to a traditional IRA? What are the pros and cons of contributing after tax income to a traditional IRA versus opening a brokerage account?

If I do contribute, am I still limited to the $5,500 cap for under 50 year olds. What is the penalty if I exceed this cap?

Thanks!

Billy T.

 

Hi Billy,

Thanks for your question.  You are correct that your income of $69,000+ prevents you from deducting contributions to a Traditional IRA.  However, you still have two options with valuable tax advantages.

1.  Roth IRA

A single person with income less than $112,000 can contribute the full amount to a Roth IRA.  You can see the full table of income limits here.  If your tax rate stays the same, a Traditional IRA is financially equivalent to a Roth IRA with the only difference being when you pay taxes.  Roth IRAs pay taxes up front while Traditional IRAs pay taxes on withdrawals.

Roth vs Traditional Equivalence
Same Tax Rate Increasing Tax Rates Decreasing Tax Rates
Roth = Traditional Roth > Traditional Roth < Traditional
Roth Traditional Roth Traditional Roth Traditional
Pre-tax Investment $5,000 $5,000 $5,000 $5,000 $5,000 $5,000
Current Tax Rate 25% 25% 25% 25% 25% 25%
Initial Investment $3,750 $5,000 $3,750 $5,000 $3,750 $5,000
Annual Rate of Return 8% 8% 8% 8% 8% 8%
Time (years)  30  30  30  30  30  30
Account value at retirement $37,735 $50,313 $37,735 $50,313 $37,735 $50,313
Future Tax Rate 25% 25% 30% 30% 20% 20%
Taxes Owed $0 $12,578 $0 $15,094 $0 $10,063
Net at Retirement $37,735 $37,735 $37,735 $35,219 $37,735 $40,251


2.  Non-deductible Traditional IRA

You don’t say how high your income is, but I would recommend that you contribute to a Roth IRA if you are eligible.

If your income exceeds the limits to contribute to a Roth IRA, you still have the option of doing a Non-deductible Traditional IRA, as you suggest in your question.  For those who don’t know, the way this works is that you contribute to a Traditional IRA, but you are unable to deduct the contribution from your taxes.  Because you have already paid taxes on this money, your investment has a “cost basis” of the amount you contributed.  You must track this cost basis and report it on your taxes each year.  When you withdraw money from the account in retirement, you pay taxes only on your investment gains.

The “pro” of contributing to a non-deductible IRA is that there can be tax savings over contributing to a taxable brokerage account.  Where is the tax savings if you paid taxes on the contributions up front and have to pay taxes on the investment gains at retirement?  It’s tricky, but the answer is that deferring the payment of taxes in this type of account results in lower total taxation because your investment has an opportunity to compound before being taxed.

Example:  If you invest a dollar and earn 20%, you have $1.20.  If there is a 50% tax on gains, you are left with only $1.10.  If you repeat this the following year you would have $1.21 (20% of $1.10 = $0.22; 50% tax = $0.11; Total = $1.10 + $0.22 – $0.11 = $1.21).  What would happen if you could have deferred taxes until the end of those 2 years?  Your dollar would become $1.20 after the first year.  You could reinvest the FULL amount of $1.20, not the after tax amount of $1.10.  So at the end of the second year you would have $1.44 before taxes.  You would then have to pay the 50% tax on your cumulative investment gains of $0.44 so your tax would be $0.22.  You would be left with $1.22 ($1.44 minus $0.22), which is greater than $1.21.  This may not seem like much, but this example is with only two years of compounding.  Many retirement savers have 30 or more years to invest for retirement so the difference can be substantial.

Here’s another example of the value of tax deferment via a non-deductible IRA:


After-tax Retirement Payoffs of Equivalent Investments in Different Account Types
Roth Traditional Non-Deductible Traditional Taxable (Middle Income) Taxable (High Income)
Pre-tax Investment $5,000 $5,000 $5,000 $5,000 $5,000
Current Tax Rate 25% 25% 25% 25% 25%
Initial Investment $3,750 $5,000 $3,750 $3,750 $3,750
Annual Rate of Return 8% 8% 8% 8% 8%
Time (years)  30  30  30  30 30
Account value at retirement $37,735 $50,313 $37,735 $32,831 $33,052
Future Tax Rate 25% 25% 25% 15% 23.8%
Taxes Owed $0 $12,578 $8,496 $4,645 $6,974
Net at Retirement $37,735 $37,735 $29,239 $30,069 $26,078
*Assumes 2% Dividend Yield; Future Tax Rate = Capital Gains Tax Rate for Taxable Accounts (15-23.8% depending on income) OR Income Tax Rate Estimate of 25% for IRAs

The main “con” of contributing to a non-deductible IRA (or any tax-advantaged retirement account) is that there are penalties for withdrawing the money prior to retirement so you have limited access to the money relative to a taxable brokerage account.  Another thing to consider is that gains in a taxable brokerage account will be taxed at the capital gains tax rate, which is less than the ordinary income tax rate that will be accessed on the gains in your non-deductible IRA.  All of this is moot, however, because of the backdoor Roth IRA.

The Backdoor Roth IRA

While a Non-Deductible Traditional IRA is often better than a taxable account, there’s actually an even better option for high earners.  Starting in 2010, the government removed the income limits for IRA conversions.  This means that anyone, regardless of income, can convert a Traditional IRA to a Roth IRA by completing the conversion process and paying taxes on the pre-tax Traditional investment and any gains.  So if you are not eligible to contribute to a Roth IRA because of a high income, you can contribute to a Non-Deductible Traditional IRA and then immediately convert it to a Roth IRA. You will only have to pay taxes on any increases in value of your investment between the time you make the contribution (the “cost basis” amount) and your conversion, so if you do this immediately your tax bill should be zero.

So to summarize:  Everyone can do a Roth IRA regardless of income, either directly or through the Backdoor Roth IRA method.  I would suggest contributing to a Roth IRA or Traditional IRA (depending on your view of where taxes are going) because the tax advantages are significantly greater than those of a Non-Deductible IRA or a Taxable Brokerage Account.

Step-by-Step Guide to Opening a Backdoor Roth IRA

The Pro-Rata Rule

Backdoor IRAs sound great, right?  Yes, but there is one big catch.  The IRS requires that all rollovers from Traditional to Roth IRAs be done pro-rata.  This means that if you have $90k in deductible contributions and $10k in non-deductible contributions, you cannot choose to rollover the $10k.  If you rolled over $10k (10% of your total account value), the government would treat this as you rolling over 10% of the deductible portion ($9k) and 10% of the non-deductible portion ($1k), which wasn’t your goal at all.  The only way to rollover the full non-deductible contribution is to rollover ALL of your traditional assets.  This may make sense if you believe tax rates will go up in the future, but be prepared for a potentially large tax bill that you must pay immediately.  Also, keep in mind that workplace SEP IRAs are also considered Traditional IRA assets for purposes of calculating pro-rata rollovers.

Contribution Limits

Regardless of whether you contribute to a Traditional IRA, Roth IRA, or Non-Deductible Traditional IRA, the limits stay the same.  Those under 50 may contribute up to $5,500 in 2013, while those over 50 may contribute $6,500.  If you contribute more than is allowed, the government will charge you a 6% excise tax.  If you do this accidentally, you have until the date you file your taxes for the year to withdraw an over-contribution and any earnings on that contribution without penalty.  You also have the option of applying this year’s over-contribution to the following year, as long as you don’t exceed that year’s limit.

Accidentally exceeding the limit is easier than it sounds.  In addition to contributing more than the $5,500 or $6,500 limit, you can also “exceed the limit” by contributing anything to a Roth IRA if your income exceeds the strict limits.  So if someone receives a much larger December bonus than expected, their Roth IRA contributions of $5,500 or less may all be above the limit and subject to the excise tax.

Choosing the Right Roth IRA

If you decide to go ahead with a Backdoor Roth IRA, be sure to think carefully about your preferred asset classes so that you invest with a brokerage that best meets your needs.  Long-term passive mutual fund investors should choose an account like Scottrade with more than 3,000 no transaction fee funds and low expense ratios on index funds (as low as 0.095%).  If you trade stocks in your IRA, look for an account with access to top 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.

 

Photo credit:  Burglar behind door by Shutterstock

We want to hear from you and encourage a lively discussion among our users. Please help us keep our site clean and safe by following our posting guidelines, and avoid disclosing personal or sensitive information such as bank account or phone numbers. Any comments posted under NerdWallet's official account are not reviewed or endorsed by representatives of financial institutions affiliated with the reviewed products, unless explicitly stated otherwise.