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?

Visit the “Ask Joanna” homepage or submit a question by emailing it to markets@nerdwallet.com.

 

Photo credit:  Burglar behind door by Shutterstock

  • http://nairobisales.blogspot.com/2012/10/cars-for-hire-in-nairobi.html Business Accounting Software

    The owner decided after the event to donate half of
    the proceeds back to the students. Unfortunately for me as an addict, I need
    my crime fix. Cranberry studios developed this sequel while publisher Anaconda brings it
    to you in stores.

  • Joanna Pratt

    Yes, anyone of any income level can do a backdoor Roth IRA. Here is a step by step guide: http://www.nerdwallet.com/blog/investing/2013/backdoor-roth-ira-high-income-how-to-guide/

  • sdr984

    You had me at backdoor

  • craig

    Is there any way around the pro-rata rule? For example, if I have a traditional IRA with Vanguard, can I open a new IRA with another company for my non-deductible contributions, and then just roll that new IRA over to a ROTH, as it would be 100% non-deductible contributions?

  • craig

    What about if I do it via my wife? She has a ROTH IRA today, but no traditional IRA. She doesn’t work, but can I do a traditional spousal IRA contribution (non-deductible), and then convert that from her traditional IRA (which would only contain the money we deposited) to her ROTH, which would give me the same net result, just that the money would be held in my wife’s ROTH IRA instead of mine? Or would the pro-rata rule somehow take into account my IRA holdings and treat those as joint funds? (The IRA funds are in my name, and my wife is the beneficiary.)

    • Joanna Pratt

      This should be okay. The IRS Form treats assets as belonging to individuals for the pro-rata rule, even if filing a joint tax return.

  • Pratima Boinepalli

    Hi Joanna

    We make more than the income limit for ROTH contribution. My husband has a retirement plan ( 401 and 403b through his employer and I have no retirement plan. What is a good way to contribute to a ROTH. Can I do a non deductible Traditional and convert it to ROTH. Does it matter on whose name it is , me or my husband.

    • Joanna Pratt

      You and your husband can each contribute up to $5500 to a non-deductible Traditional IRA and then convert it to a Roth IRA. The name does not matter and you can do one in each of your names if you want. If you have any other Traditional IRA assets, the pro-rata rule will apply.

  • Joanna Pratt

    The money you put into your Roth IRA was already taxed when you earned it. You declare the contribution on your tax return the following April, but no additional taxes are owed. The contributions to a Traditional IRA, by contrast, are tax deductible so you get the taxes back that you paid on the contributions when you earned them by filing your tax return.

  • Joanna Pratt

    Many employer plans have rules on what can be transferred in, but if your non-IRA work plan will allow a partial transfer of only deductible traditional assets, leaving you with only non-deductible assets in your traditional IRA, then yes, in theory that would be a way to avoid the pro-rata rule.

  • rrgg

    I have 2 scenarios. (a) I contribute to a Traditional IRA now and convert it to Roth. Then next January I do the same thing – contribute to a new Traditional IRA and convert it. (b) Or I contribute to a Traditional IRA now, then contribute again in January. In March 2014 I convert the 1 account all at once. I think both cases are allowed, but (b) seems like a little less hassle. Or have I misunderstood? Or maybe (a) is less hassle on tax forms. Thanks.

  • Ken

    So once I convert a traditional IRA over to a Roth am I allowed to to contribute to that Roth the following year? Or will I have to create another Traditional IRA and convert year after year?

    • Joanna Pratt

      You would have to contribute to a Traditional IRA the following year and convert it again. Many companies (Vanguard does this) leave your old Traditional IRA open even with zero balance so it’s actually just a matter of contributing to the empty Traditional IRA from last year and converting again with a simple form.

  • Frank

    I’d like to contribute the full $6,500 to my Roth IRA at the beginning of the year for 2014. What happens if 6 months down the road I get a raise and it puts me slightly over the cap? Will it be as easy as just applying the overage to the subsequent year’s reduced amount? I’m brand new to this so I’m really worried about making an expensive mistake.

  • cio

    My husband and I each file married filing separately. How can I benefit most from an IRA contribution since it seems that neither of us can contribute to a Roth?

  • Kevin

    can we do multiple conversions in a single year ? one now before apr-15 going against 2013 contrib limits and another one later in the year for 2014 ?