Roth IRAs - In the Backdoor
By Greer Gibson Bacon, CFP®
Roth IRAs are a great financial planning tool for high income earners. They shelter income from tax now. They can provide tax-free income later. They help minimize the Medicare sur-tax on net investment income and surcharge on Medicare premiums. They’re a great inher-itance for children or grandchildren. If you’re a high income earner, the problem is getting money into one.
Under current law, Roth contributions are phased-out when modified adjusted gross income (MAGI) reaches a certain threshold. For 2015, the phase-out begins at $116,000 for single tax-payers and $183,000 for married taxpayers filing jointly. For 2016, these thresholds increase by $1,000.
Importantly, no income limitations apply to Roth conversions. This means high income earners can contribute indirectly. Here’s how this works.
Step 1: Eliminate pre-tax dollars in all traditional, SIMPLE and SEP IRAs.
There are two ways to do this. If balances are small and you don’t mind paying taxes now, simply convert them. If they’re large and you want to defer taxes until later, roll them into a qualified plan, like your 401(k) or 403(b). Since only pre-tax IRA dollars can be rolled into a qualified plan, your after-tax contributions (if any) will remain in your IRA. This is great news as they can be converted to your Roth in Step 3.
Although most employer plans accept incoming transfers, you should confirm this with your employer. If yours doesn’t, you may be able to create an alternate plan. For example, if you have self-employment income from teaching outside of your regular employment, you may be able to set-up a solo 401(k) and transfer your IRA into it.
Step 2: Make a non-deductible contribution to a traditional IRA.
For 2015 and 2016, you may contribute up to $5,500 of earned income to a traditional IRA if you’re under age 50 or $6,500 if you’re age 50 or older. If you participate in an employer plan, contributions become non-deductible for single taxpayers when MAGI reaches $71,000 and married taxpayers filing jointly when it reaches $118,000. Importantly, non-deductible contri-butions are made with after-tax dollars.
Step 3: Convert your traditional IRA to a Roth.
When you convert a traditional IRA to a Roth, most of the conversion amount will be non-taxable because it will be composed of your non-deductible contribution. If the time elapsed between your contribution and conversion is short, earnings (if any) will be minimal. That said; they will be taxed as ordinary income.
Backdoor Roth IRAs are best used by high income earners who can’t contribute directly to a Roth IRA, but can make non-deductible contributions to a traditional IRA. If you fall into this group and want to implement this strategy, it is important to follow the prescribed steps care-fully to avoid a negative tax consequence. If you’re not sure a Backdoor Roth is a good strategy for you, please consult with an experienced financial or tax advisor.
This article first appeared in the February 2016 Spokane County Medical Society Magazine. The information referenced in the article is current as of date of publication.