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I am self-employed. I used to put money in Roth IRA but then I started to make more than the limit so I stopped. I now read your article about the backdoor Roth. I put the max allowed for self-employed in an SEP IRA. I'm also able to put $6,000 (the maximum allowed in 2019) in a traditional IRA that I then want to convert into a backdoor Roth. Do I need to reduce my SEP IRA contribution to $50,000 [to account for the $6,000 IRA contribution] to set this up? Or are the SEP IRA and traditional IRA considered separate IRAs? I have 20-plus years until retirement. -Yasu
The government places no restrictions on contributing to both a SEP IRA and a traditional IRA in the same year. So, you do not need to reduce your SEP IRA contribution to also contribute to a traditional IRA.
As you note, however, there are income limits to deducting contributions to a traditional IRA. As this IRA contribution limits table shows, those with workplace retirement plans can only take the full deduction on a traditional IRA if their income is less than $64,000 ($103,000 if married and filing jointly).
For high earners like you, the $56,000 SEP IRA contribution (the maximum allowed by the IRS in 2019) would be tax deductible, while the $6,000 contributed to the traditional IRA would not be.
» Learn whether a SEP IRA is right for you. See the pros, cons and key details about SEP IRAs.
So, can you get that non-deductible money into a “backdoor” Roth IRA? Yes, but be careful.
There are no income limits on rolling over a traditional IRA to Roth IRA, so you are certainly welcome to do so. The catch is that the government requires all rollovers from traditional to Roth IRAs be done on a pro-rata basis. This means that if you have an account with a $56,000 SEP IRA contribution and a $6,000 nondeductible traditional IRA contribution, you cannot choose to just rollover the $6,000. If you rolled over $6,000 (9.7% of all of the $62,000 total), the government would treat that like you were rolling over $5,418 (or 9.7%) of the SEP and $582 (also 9.7%) of the non-deductible traditional IRA, which is not what you intended at all. Unfortunately, you don’t have the option of designating which dollars are getting rolled over.
The only way to rollover the full non-deductible amount into a Roth IRA would be to rollover all of your traditional assets (this includes the full value of your SEP IRA and other traditional IRA accounts). If you think taxes will go up in the future, this might not be a bad idea, but you will owe the taxes immediately. If you have been contributing to the SEP IRA for some time, your tax bill could be substantial.
» To Roth or not? To help you choose, see our Roth IRA vs. traditional IRA comparison.
If you’re not ready to convert it all to Roth, you still have the option of making the non-deductible IRA contribution and just leaving it non-deductible. The tax advantages are not as great as with a deductible traditional IRA or a Roth IRA, but this structure is still superior to a fully taxable account due to the deferment of dividend and capital gains taxes for your 20-plus years until retirement.
» Get it done. Learn how and where to open an IRA
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.
This article originally appeared on NerdWallet in April 2013. It has been updated to reflect 2019 contribution limits.
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