Since their introduction in 1998, Roth IRAs have become an important part of the financial planning landscape. They offer the unique ability for investors to grow their money tax-free, not simply tax-deferred like traditional IRAs. They also avoid required minimum distributions so they can grow undiminished for many years. In fact, Roth IRAs are wonderful assets to pass along to the next generation, where they can continue to grow tax-free even longer.
Until recently, this unique retirement vehicle was available only to individuals with incomes below certain thresholds. “High-income” individuals could not contribute to Roth IRAs or convert traditional IRAs into Roth IRAs. Some of this changed in 2010, when the Roth conversion income limitations were permanently repealed. Now, anyone (regardless of income) can make a Roth conversion. However, the Roth contribution limitation was not repealed. This means that if your income exceeds the levels in the table below, you cannot contribute directly to a Roth IRA—but you can achieve the same result by first contributing to a non-deductible traditional IRA and then converting it to a Roth IRA.
This presents an interesting opportunity for high income individuals, who perhaps yearn to save beyond their 401(k) or 403(b) retirement plans or who simply desire the account diversification that comes with adding a Roth vehicle to their retirement mix.
These individuals have the potential to now fund what’s known as a “backdoor” Roth IRA by funding a non-deductible traditional IRA and then immediately converting it to a Roth. This may seem a round-about way, but there’s a reason it has to be done this way.
The reason lies in the income limitations for contributing to the different IRAs. For illustrative purposes, the table below shows the income limits for contributing to and converting to Roth IRAs. (If your income is below these amounts, this strategy should not be necessary for you.)
|Roth IRA contribution - income limitation|
|> Married, filing jointly||$176k||$177k||$179k|
|Non-deductible Traditional IRA contribution - income limitation||none||none||none|
|Roth IRA conversion - income limitation||$100k||none||none|
As the chart shows, a married couple earning, say $200,000, cannot contribute to a Roth IRA, even under current rules. Before 2010, they could have contributed to a non-deductible traditional IRA, but they couldn’t convert that to a Roth because of their income.
This year and in the future, that couple can fund a non-deductible traditional IRA and then immediately convert it to a Roth, since the Roth conversion limitation has been removed. This effectively circumvents the Roth IRA contribution limitation. With proper timing, there should be very little, if any, tax consequence on the conversion since the non-deductible traditional IRA contains, by definition, post-tax dollars which would not be taxed again.
This strategy works best for taxpayers who have no other pre-tax IRAs, such as a rollover or contributory IRA. If you have other pre-tax IRAs, you may be subject to pro-rata rules on the Roth conversion that would severely diminish the appeal of this strategy. If this applies to you, we recommend that you consult with a tax professional before attempting this strategy.
Even if you do have other pre-tax IRAs, there are potential moves that might let you benefit from the “backdoor” Roth. You might be able to roll your pre-tax traditional IRA into your employer retirement plan (such as a 401(k) or 403(b)) first, and then perform the Roth conversion. This strategy is particularly compelling for self-employed individuals who may be able to establish their own Solo-401(k) into which they can roll over pre-tax IRA accounts. Again, we recommend that you consult with a tax professional before attempting this.
It is clear from the income thresholds that the “backdoor” Roth will only apply to a limited number of individuals, those with high incomes and no other pre-tax traditional IRAs. But for those who qualify, the “backdoor” Roth IRA can open up access to a highly tax-efficient retirement vehicle that was previously out of reach.