Enter the backdoor Roth IRA
While IRA contribution limits are small relative to 401(k) contributions, you should not underestimate the might of a Roth IRA. The challenge with Roth IRAs is that the IRS puts a cap on contributions for high income earners. Your ability to contribute to a Roth IRA is completely phased out if you make over $139,000 ($140,000 in 2021) as a single person, or $206,000 ($208,000 in 2021) as a married couple filing jointly.
There is no income limit nor annual limit on the amount you can convert to a Roth via Roth conversions, but are just moving dollars from one tax-advantaged account to another. Same goes for rolling over an old traditional 401(k) or Roth 401(k).
You are looking to put NEW money into a Roth and your employer does not allow Mega Backdoor Roth contributions, or maybe you are supersaver and have already maxed that out.
Two-step Roth IRA contribution
A backdoor Roth IRA contribution is a two-step process for high earners to get NEW money into a Roth IRA.
👉🏼 Step 1: Make a non-deductible contribution to a traditional IRA
High earners cannot make a direct contribution to a Roth IRA, period. The IRS does not prohibit high earners from making contributions to a traditional IRA, however, the up-front tax benefit is completely taken away if you are single and earn (MAGI) above $75,000 in 2020 ($76,000 in 2021). If you are married filing jointly, the income limit is $124,000 in 2020 ($125,000 in 2021).
Side note: these limits assume that you are covered by an employer-sponsored retirement plan, such as a 401(k). If you are covered but your spouse is not, or your spouse does not work, the income limit to make a tax-deductible IRA contribution for the non-working spouse is $206,000 in 2020 ($208,000 in 2021).
With non-deductible contributions, the contribution is not taxed again, but the growth is taxed as income at withdrawal. For example, Emmitt contributes $6,000 in 2020 and his account grows at 8% per year. In 20 years, the account will be worth close to $28,000. If Emmitt were to take a lump sum distribution, the contribution of $6,000 comes out tax free, but the growth, or $22,000, is taxed as income.
Side note: these limits assume that you are covered by an employer-sponsored retirement plan, such as a 401(k). If you are covered but your spouse is not, or your spouse does not work, the income limit to make a tax-deductible IRA contribution for the non-working spouse is $206,000 in 2020 ($208,000 in 2021).
With non-deductible contributions, the contribution is not taxed again, but the growth is taxed as income at withdrawal. For example, Emmitt contributes $6,000 in 2020 and his account grows at 8% per year. In 20 years, the account will be worth close to $28,000. If Emmitt were to take a lump sum distribution, the contribution of $6,000 comes out tax free, but the growth, or $22,000, is taxed as income.
Taxation of non-deductible IRA contributions at withdrawal
If Emmitt were to withdraw half, the taxable and tax-free amounts are assumed to be taken proportionally. Emmitt withdraws $14,000, $3,000 is considered tax-free, and $11,000 is considered taxable income.
Nondeductible contributions to an IRA may not make sense for a number of reasons.
Had you contributed the $6,000 to a taxable account, the gain would be taxed at a more favorable capital gains tax rate.
IRAs have required minimum distributions starting at age 72, and you partially lose control of the timing of the distribution. Individual accounts do not have withdrawal requirements.
Individual accounts can get a step-up in basis at death, and your heirs may end up not paying any tax on the gains.
One advantage of a non-deductible IRA contribution is the tax deferral on the growth, but you can achieve similar results by investing in growth-oriented assets that do not produce dividends or other current income.
This is a moot point however, because Emmitt can make an extra step to turn a non-deductible IRA contribution into a Roth IRA contribution.
✌🏼 Step 2: Make a Roth conversion by transferring the IRA contribution to a Roth IRA
Recall that there is no income limit on Roth conversions. A backdoor Roth IRA contribution is executed by making a non-deductible contribution to a traditional IRA, then immediately transferring it to a Roth IRA.
Roth conversions of pre-tax IRA contributions result in the amount of the conversion being taxed as income. However, non-deductible IRA contributions are already taxed, and do not get taxed again. Therefore, Roth conversions using non-deductible IRA contributions are not taxed, and effectively gives the same tax advantage as contributing directly to a Roth IRA.
Roth conversion makes growth tax-free at withdrawal
🛑 Watch out for the Pro-Rata Rule
The IRS says that any money taken out of an IRA account is taxed proportionately between taxable and tax-free money. Said another way, you cannot pick and choose where you want to take the distribution from.
If you have an IRA with pre-tax dollars, the pro-rata rule makes it prohibitive to make backdoor Roth IRA contributions.
For example, Emmitt has a $100,000 IRA made with pre-tax dollars from many years ago when his income was lower. Emmitt is now a high-earner and cannot make tax-deductible IRA contributions or Roth IRA contributions.
In order to get around the pro-rata rule, Emmitt opens a new IRA, makes a non-deductible IRA contribution, and converts it to a Roth IRA. This does not work. The IRS takes all of your IRA accounts into consideration, even if you open a completely separate IRA account. Due to the pro-rata rule, the $6,000 distribution is considered 94% taxable ($6,000 / $106,000), and Emmitt will need to pay income tax on $5,660.
Beating the Pro-Rata Trap
While the pro-rata rule looks at all of your IRA accounts, they do not count the money in a 401(k). Therefore, one way to beat the pro-rata trap is to roll your pre-tax IRA into your 401(k). This clears out any pre-tax money in your IRA, and opens the door to make backdoor Roth contributions!
Your employer’s plan must allow roll-ins, but most plans do because plan administrators typically charge your employer less the more assets they have in a 401(k) plan.
If you are a high earner and are not taking advantage of a backdoor Roth IRA contribution, you might be paying $180,000 more in taxes in the future. If you found this article to be helpful and would like to work with me to develop and execute a financial strategy for you, schedule a call with me.
Not tax, legal, or investment advice. Consult a professional.
