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How to Contribute to a Roth IRA When You’re a Top Earner

How to Contribute to a Roth IRA When You’re a Top Earner

There is such a thing as making too much money. If you’re single with adjusted gross income of more than $131,000 in 2015 and more than $193,000 for joint filers, you can’t contribute directly to a Roth IRA.

But, there is more than one way to skin a cat, even one called Uncle Sam.

Here’s how to take advantage of the "Backdoor" strategy.

Contribute to a Traditional IRA

You can put $5,500 into a Traditional IRA, and if you’re 50 or older you can contribute as much as $6,500. Keep in mind however that you will not get a tax deduction. "Folks who make too much money to contribute to a Roth IRA generally also make too much money to deduct Traditional IRA contributions," says Ben Birken, a certified financial planner with Woodward Financial Advisors.

Convert the Traditional to a Roth IRA

You contribute to a Traditional IRA and convert it to a Roth IRA. Seems pretty simple to do, but, "there is no such thing as easy when it comes to the Internal Revenue Service and our tax laws," says Jonathan Gassman, CPA, CEO and founder of The Gassman Financial Group.

It’s tricky. "The problem with the Backdoor strategy is that it is only tax-free if the owner does not have any other IRAs. That’s because the IRS will consider different IRA accounts as one account," explains Scott Stratton, a certified financial planner and founder of Good Life Wealth Management. Any distribution would be considered a pro-rata distribution from all sources. "This means that you can’t pick which account you would convert in a Backdoor strategy."

The problem with the Backdoor strategy is that it is only tax-free if the owner does not have any other IRAs.

To understand how this works, take Bob who makes too much money to buy a Roth or qualify for a tax deduction on a Traditional IRA. He hears about the Backdoor Roth conversion so he puts $6,500 all after-tax into a Traditional IRA and converts it to a Roth IRA. However, Bob has another $200,000 in a Traditional IRA, all pre tax. So now Bob’s total in IRAs is the $200,000 before tax with his new contribution of $6,500 after tax for a total of $206,500 in IRAs. Out of this, only $6,500 is after tax, which is 3% of the $206,500. So when Bob pulls his $6,500 out of the Traditional IRA to convert it to a Roth IRA, 3% of this money would be after tax and 97% would be taxable.

"What’s really bad is Bob just took $6,500 that he already paid taxes on, and is now paying tax on 97% of it ($6,300) again. You just don’t want to go there," says Mike Piershale, president of Piershale Financial Group.

You aren’t allowed to cherry pick the dollars you want to convert. So if you already have a Traditional IRA that has a mixture of pre-tax and after-tax dollars, you can’t just convert the after-tax dollars. Instead, any conversion is taxed pro-rata, based on the ratio of pre- and post-tax dollars in the IRA. "This is referred to as the ‘cream in the coffee rule’ – if you put cream in your coffee and then realize you didn’t want cream, you can’t just take out the cream," say Birken.

To avoid a pro-rata tax calculation that can eliminate most of the benefit of a Backdoor strategy, the best thing to do is roll the entire amount into a newly created individual 401k/403b, or if you like your employer’s plan, roll it into your employer’s 401k/403b, advises Chase Cawyer, a wealth management advisor with Navigo Wealth Management. "You need to get rid of any individual IRA (SEP-IRA, SIMPLE IRA, traditional IRA or rollover money first."

Reality check

"I am staunchly opposed to employing the strategy because I believe the IRS will at some point crack down on this method. I believe this is going to become an issue for many investors in the near future, one which could be applied retroactively to those who employ this strategy," warns Michael Bukowski, a certified financial planner with RMB Wealth Advisors.

Essentially, he explains, the tax code considers a series of economic transactions that have an intention of circumventing or avoiding taxes, should be taxed on the overall economic value of transaction. "They call this a ‘step transaction’. I and other notable financial planners think this will cause investors to run afoul of the IRS," says Bukowski.

Birken adds, "The IRS hasn’t come out and explicitly said the Backdoor strategy is okay. They haven’t completely outlawed it either. It’s kind of a gray area."

The Backdoor strategy is a great option for some, but not everyone. Says Thomas Walsh, an investment analyst with Palisades Hudson Financial Group, "Your age will be a large factor, because the length of time a contribution will grow in a given account may make it a more or less attractive option. In addition, you should consider the likelihood that you will remain in a similar tax bracket in retirement. If you expect to drop to a lower one, or to move to a more tax-friendly state, consider your options in light of these long-term plans."

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DCGuy (anonymous)   |     |   Comment #2
Ths strategy is best when you make a lot of money when you are young.  If you are close to retirement, the benefits are not that dramatic.  Also, since you still being taxed "up front" when you make the contributions, you have less time to recoup the money paid out from the beginning.  An older age means less time to invest the money and if you have a smaller time window, a down market trend could really backfire on you.
Anonymous   |     |   Comment #3
I don't see how age has anything do to with it.  If you're a high income earner then your choices on what to do with the $6K is to 1) leave it in a taxable account, 2) contribute towards a non-deductible IRA, or 3) backdoor the amount tax-free into a Roth IRA.  Is there ever a time when #3 is worse than #1?  Down markets only matter for required minimum distributions, which don't apply for #1 or #3.
Anonymous   |     |   Comment #4
Wow Anonymous #3,  Down markets  affect more than just required minimum distributions when it comes to financial planning, particularly a person's retirement years.   
Anonymous   |     |   Comment #5
The point is about what does a down market have to do with whether someone should do a backdoor Roth or not.  I.e., how does being in a Roth compound the problem of a down market?  With a 401(k) or a traditional IRA you're forced to sell when the market is low, but that's not relevant for a Roth.
Anonymous   |     |   Comment #6
I am in my 70's. Not wealthy but have more than I need for daily living. I give to my children every Jan 1. I do conversions so the children will not have to pay income taxes on a traditional IRA they would inherit. I use a conversion as an estate planning technique. 
Anonymous   |     |   Comment #7
I'm confused by the 'realty check' described in the article.  The IRS started permitting conversions of traditional IRAs to Roth IRAs (five or ten years ago) presumably as a result of legislation, with the (again, presumably) intention of increasing near term tax revenue (a person pays tax on traditional IRA contributions and earnings during conversion to the extent such amounts were not previously subjected to tax).  But as noted in the article, not all contributions to traditional IRAs are made with pre-tax dollars.  Since the IRS did not limit conversion to amounts not previously subject to tax, how are the economics different between those instances and instances when the backdoor strategy is used?  (I am one of those people, so I'm really curious what others think.)  And if the IRS did refine their position, would it really be retroactive?  And finally, even if it is retroactive, I wouldn't be in any worse off position than if I hadn't used the strategy (i.e., the amounts would have been invested in taxable accounts).
Anonymous   |     |   Comment #8
The IRS doesn't have much say in the matters--they're basically a set of clerks carrying out the laws as passed by congress.  Congress got rid of the conversion limit to help pay for some of the Bush tax cuts.  It's debatable whether the ability to convert post-tax funds & make backdoor contributions are an intentional vs accidental benefit.  Given that it was republicans that implemented a change that benefits the rich I think it's naive to think it's accidental.

Anyway, the warning is that there's an IRS rule/policy that says that if someone uses multiple steps to achieve something that can be accomplished using fewer steps (for the purposes of reducing/avoiding tax) then the transaction can be taxes as if the fewer steps was actually used.  The worse case (for those that believe the "reality check") is that the IRS could decide that the backdoor contributions are to be treated as excess Roth IRA contributions.  This means you could be subject to a 6% excise tax on the backdoor.  To me it seems like congress, the president, and the IRS are too aware of backdoor roths for this to happen (and if it did it seems like the legislative branch would be apt to pass legislation to override that action by the IRS).
Anonymous   |     |   Comment #9
Thanks... that is helpful.  I've also read other commentary that suggests you should contribute to the traditional IRA and then wait, perhaps as long as six months, before completing the conversion.  That will be my plan for 2016.