If you’ve already maxed out your 401(k) contribution and have an income that tops the IRA tax-deduction and Roth contribution limits, you may think you’ve already exhausted your tax-advantaged options. What most people don’t know is that there’s one more little-known IRA option for high income earners. It’s known as the Backdoor Roth IRA.
What is a Backdoor Roth IRA?
The Backdoor Roth IRA is made possible by a tax loophole that gives high income earners the ability take advantage of the tax-advantages offered through the Roth IRA.
To understand how it works, let’s first take a quick look at traditional and Roth IRA rules.
The traditional IRA was established in 1974 to allow an investor to save retirement funds on a tax-free basis through a tax deduction on annual contributions. IRA benefits are similar to those seen within a defined contribution retirement plan like a 401(k) in that contributions are made on a pre-tax basis and all earnings aren’t taxed until the funds are distributed (so the investor gains the benefit of greater compound interest). One caveat is that an IRA doesn’t come with any sort of matching bonus (because there is no employer involved to conduct the match) and the tax deduction is only available to those below certain income limits.
Single tax filers who make below $70,000 and married, joint filers who make below $116,000 (for 2014) can benefit from some level of a tax deduction from a traditional IRA (Phase out limits apply. Income limits are higher for those who are not covered by a retirement plan at work. See the IRS website for up-to-date income guidelines.)
What’s important to know (for those considering the Backdoor Roth IRA) is that the tax law changed in 2010 so that now anyone can contribute to a traditional IRA, no matter your income level. You can’t deduct the contribution if your income level is above the IRS limits (more on this below) but in just a few minutes I’ll explain how high income earners can use this back door and get tax advantages.
Established in 1997, the Roth IRA does not come with a tax deduction but offers a benefit many investors find to be even more valuable – tax-free earnings. To explain: an investor contributes to a Roth IRA but cannot take a tax deduction on the contribution. In the following years, as the account grows, all earnings accrue tax-free forever.
Even when the money is distributed in retirement, there are no tax consequences for the investor.
The Roth IRA is a popular option for those (like me) who expect taxes will rise in the future.
Unlike the traditional IRA, you cannot contribute (directly, which we’ll discuss below) to a Roth IRA at all if your income is above certain limits. IRS limits for 2015 are below $193,000 for joint filers and $131,000 for single filers.
Backdoor Roth IRA
So, if you’re a single-filer, for example, who makes more than $131,000, if would seem that you’re out of tax-advantaged luck, beyond your employer’s 401(k) plan (or other tax-advantaged employer-sponsored plan).
But, in 2010 a change was made to the IRS tax code to remove the income limit for making a contribution to a traditional IRA, establishing a non-deductible traditional IRA. This created a back door loophole for high income earners (those above IRS limits) who cannot deduct the contribution amount from their tax bill.
Once the non-deductible traditional IRA is opened, an account owner can then can roll their traditional IRA balance into a Roth IRA. Basically, it’s a two-step process that allows high-income earners to access the benefits of the Roth IRA, despite the program’s income limits.
Backdoor Roth vs. Roth Conversion
You may have read before about converting a traditional IRA into a Roth IRA. In a straightforward Roth conversion, you can take any existing IRA balance — be it a traditional IRA, SEP, etc. — and convert it into a Roth IRA. When you do this, you are responsible for paying taxes on the amount you convert. You pay taxes on both the principal (the amount you contributed) and any earnings since the account was opened.
With a Backdoor Roth IRA, it’s sometimes possible to avoid this large tax responsibility because you’re not deducting the amount you contribute to the nondeductible traditional IRA. There is an exception, however: If your nondeductible traditional IRA earns any income (interest, dividends or capital gains) before you convert it to a Roth IRA, you will have to pay taxes on those earnings.
The downsides to a Backdoor Roth
There are two potential downsides to consider if you’re thinking about funding a Roth IRA through the back door.
1. The loophole may close soon
The recently released U.S. fiscal year budget for 2016 includes a proposal to close the backdoor Roth loophole. A recent post from Forbes opines that the proposal could stall (it’s likely to be unpopular with the Republican-controlled congress) but then again, it may not. The option may or may not be available in future years so take advantage of it while you can.
2. The pro rata rule
When it comes to taxes, nothing is easy. And this is especially true when you take advantage of loopholes.
In a nutshell, the pro rata rule states that any withdrawals you take from IRAs be equally divided between taxable and non-taxable funds.
Under the pro-rata rule, ALL of your IRA holdings will effect the tax consequences of opening a Backdoor Roth.
For example, let’s say:
- You have $45,000 in a rollover IRA created from an old 401(k).
- Then you put $5,000 in a new nondeductible IRA.
- You have a ratio of 9:1 of taxable to non-taxable money.
- When you convert the $5,000 nondeductible IRA to a Roth, you will actually owe taxes of $4,500. That’s because 90 percent of your available IRA funds has never been taxed.
If you have a sizable existing IRA balance — be they traditional IRAs, rollover IRAs, or SEPs — this could create a large tax burden for the conversion year. One answer, if you can afford to pay the taxes, is to convert all of your IRAs to Roths at the same time. In any case, if you think the pro rata rule will affect you, seek the advice of a tax professional before converting.
The backdoor Roth IRA isn’t for everyone but for some high income earners, it can be a great way to get access to a tax-advantaged retirement strategy and boost your nest egg.