Income Too High To Make A Roth IRA Contribution? Think Again!

By Baker Newman Noyes October 7, 2013

A high wage earner who has otherwise been unable to contribute funds to a Roth Individual Retirement Account (IRA) should be aware of the concept of the “backdoor Roth IRA contribution.”  A Roth IRA is desirable in that, if managed correctly, all earnings could be tax-free.  Income thresholds exist which may prohibit contributions directly into a Roth for some taxpayers.  This article is meant to highlight a possible way around the income limitations for those who wish to fund a Roth IRA but otherwise are ineligible.

To illustrate, let’s first consider the example of Jody.  Jody works full time and participates in an employer 401k plan.  Jody has no Individual Retirement Accounts of any kind, but wants to increase retirement savings this year and would like to have a Roth IRA.  Jody’s income is too high to make a deductible contribution to a regular IRA plan.  However, Jody can make a nondeductible IRA contribution which can then be immediately converted to a Roth IRA.  Administratively, this involves setting up two separate accounts and managing a simple two-step transaction.  But it does allow Jody to have a Roth IRA at the end of the day.  The conversion to the Roth IRA will be nontaxable if done immediately.  Since Jody did not get a tax deduction for making the nondeductible IRA contribution, converting those same dollars to a Roth will not be taxable.  If there were earnings between the time of contribution and conversion, those earnings would be taxable.

Note that in Jody’s example above, it’s important that Jody does not have any existing IRAs.  However, it’s sometimes possible for those with existing IRA money to accomplish the same thing.

Consider Leslie, who also works full time and has an employer 401k.  Leslie’s 401k permits rollovers into the 401k from employee’s other retirement plans, including IRAs.  Leslie has $60,000 in an existing IRA account consisting of $24,000 of nondeductible contributions made in the past with the rest representing deductible contributions and earnings.  If Leslie were to roll the entire IRA to a Roth IRA this year, Leslie would pay tax in 2013 on $36,000 of income – the amount of previously deductible contributions and earnings in that IRA.

The solution to this problem for Leslie is to remove all taxable contributions from the traditional IRA before converting.  This can be accomplished by rolling over the entire sum of taxable funds to an eligible retirement plan, such as a 401(k), 403(b) or 457(b).  To avoid current tax and obtain a Roth IRA, Leslie should first roll $36,000 from the IRA directly to the employer 401k plan.  This move will not be taxable since the money is simply being moved from one qualified plan to another and not withdrawn.  In a second step, Leslie converts the remaining $24,000 in the IRA to a Roth IRA.  While this transaction must be reported on an income tax return, the conversion should not be taxable since Leslie did not obtain a deduction for the $24,000 in that IRA when contributed.  In fact, Leslie might also have made a nondeductible contribution to the IRA first, thus increasing the amount that could be converted to the Roth tax-free.

One caution regarding investments: by rolling money from an IRA to an employer 401k plan, Leslie must be comfortable with the investment choices offered by the employer plan.  Leslie is likely to have a broader array of investments available within an IRA than within an employer 401k plan.

It’s important to structure a backdoor Roth IRA contribution or conversion correctly to avoid potentially nasty tax surprises.  If you think this strategy might be applicable to you, a member of your family, or one of your clients, please contact your BNN advisor at 1-800-244-7444.