For many higher-income earners, Roth IRAs seem to be off-limits thanks to strict income caps on these accounts.
But there is another way into a Roth—if you’re willing to take the backdoor route. By this method, you simply open a regular IRA, make your desired contribution, and then convert the funds to a Roth.
Could it really be that easy to sidestep restrictions that have kept many investors from enjoying a Roth IRA’s tax advantages? While most loopholes have some caveats—and this one is no exception—it has been gaining popularity with higher-income earners, notes Rande Spiegelman, vice president of financial planning at the Schwab Center for Financial Research.
Let’s look at the steps you need to take to open one, what taxes may be involved, and the future prospects and potential drawbacks for this retirement-savings hack.
The appeal and limitations of a Roth
First, let’s recall what can make a Roth IRA desirable, even though you get no up-front tax deduction as you do with a traditional IRA, 401(k) or other tax-deferred account.
- You pay no tax on either principal or earnings when you withdraw your money (although you must be at least age 59½ and have had the Roth for five years).
- There’s no time requirement on when you have to withdraw it, if ever—an appealing option for those wanting to leave the money to heirs.
The trouble has been, of course, that Roth IRAs technically are only available to those earning below certain income limits. In 2014 the limits are:
- $191,000 or less for couples filing jointly
- $129,000 or less for singles
Do the Roth two-step
For those interested in adding the benefits of a Roth to their plan, here is the basic two-step process.
1. Open a non-deductible traditional IRA in which only the earnings are taxed when withdrawals are made and make an after-tax contribution. For 2014, you’re allowed to contribute up to $5,500 ($6,500 if you’re 50 or older). Make sure you file IRS Form 8606 every year you do this.
2. Soon after, convert that traditional IRA to a Roth IRA. Some experts recommend waiting at least a day or two, so the contribution shows up on at least one traditional IRA statement.
Give the IRS its due
Of course, you will have to figure out the tax. If you have no other IRAs, this will be simple. The conversion triggers income tax on the appreciation of the after-tax contributions, which should be negligible after such short a time. Once in the Roth IRA, the savings compound tax-free.
But if you have other IRAs, calculating the tax hit can get a tad complicated. That’s because the IRS’s pro rata rule requires you to include all of your traditional IRA assets—that means your IRAs funded with pretax (deductible) contributions as well as those funded with after-tax (nondeductible) contributions—when figuring the conversion’s taxes. You then pay a proportional amount of taxes on the original account’s pretax contributions and earnings.
Say you contribute $5,500 to a nondeductible traditional IRA. You also have a rollover IRA worth $94,500 from a previous 401(k) made with pretax contributions. In this case, 94.5% of any conversion would be taxable. Here’s the math:
- Total value of both accounts = $100,000
- Pretax contributions = $94,500
- After-tax contribution: $5,500
- $5,500 ÷ $100,000 (expressed as percentage) = 5.5%
- $5,500 (the amount converted) x 5.5% = $302.50 tax-free
- $5,500 - $302.50 = $5,197.50 subject to income tax
Note: If your 401(k) allows you to “roll in” an IRA account, as some do, you can essentially take your existing IRA out of the conversion calculation.
Consider your estate plan
This backdoor strategy may seem best suited for younger high-income earners who haven’t already acquired large savings in traditional IRAs, but it may also appeal to those who intend to pass their Roth IRAs on to heirs, says Mark Luscombe, principal federal tax analyst for Wolters Kluwer, CCH, which specializes in tax and accounting research.
“We are getting a lot of people with wealth accumulating in traditional IRAs, facing required minimum distributions (RMDs) that could push them into a higher tax bracket,” he points out. In that situation, it can be advantageous to pay some tax now and get more funds into a Roth, which would have no RMDs.
The backdoor Roth may not last forever
Although this loophole has existed since 2010, the IRS has not officially decided whether it violates the step-transaction rule. (When applied, this rule treats what are several different steps as if they were a single transaction for tax purposes.) Experts disagree on the likelihood of this happening, but the lack of a definitive ruling means there is some risk involved. If the IRS decides that the loophole is a violation, you will owe a 6% excise tax for overfunding your Roth.
Rande notes that in theory the two-step Roth conversion could be repeated every year, circumventing Roth income limits on contributions, which seems to stretch the existing loophole. “If this is what Congress intended, it would have just eliminated Roth contribution limits along with the conversion limit,” he says. “Don't be surprised if Congress writes some sort of anti-abuse provision into the law.”
If restrictions do come into play at some point, they could require backdoor Roth converters to pay a penalty (as in the IRS rule above) or they might include a grandfather clause. In the meantime, it’s an option to consider since the backdoor conversion has tax and estate planning benefits that could suit your plans.