Roth IRA Contributions for High Income Earners

In our recent post regarding retirement plans for self-employed individuals, we included a summary of each plan with a sub-section on “Ability to Also Contribute to Roth IRA (Backdoor)” as shown below.

This post will expand on Backdoor Roth IRAs as a way for high income earners to make Roth IRA contributions in spite of being above the IRS mandated maximum income level to contribute to a Roth. The permissibility of Backdoor Roth IRAs was unclear under prior tax law; however, the recently enacted Tax Cuts and Jobs Act appears to allow the utilization of this strategy.  As always, we recommend that you consult your CPA or tax advisor to confirm this approach is appropriate for you. 

What is a Roth IRA?

A Roth IRA is a retirement account which is funded with after-tax dollars. Once the Roth contribution is made, the funds can be invested for long-term growth.  The advantage of a Roth is that all future growth on your contribution is tax free. For young people, the compound effect of tax-free growth can be significant.

Consider the following scenario, a 30-year-old wishes to maximize Roth IRA contributions – $6,000 for 2019 plus $1,000 catch up at age 50 or older – until age 65. Assume contribution amounts are allowed an increase each year by a 2% inflation rate and the Roth IRA investment growth is 7% annually.

Under these assumptions, the example 30-year-old has contributed a combined $339,663 to a Roth IRA and the account balance is $1,255,136. That full account balance (~$1.25 million) would be treated as completely free of tax when withdrawn.

There is one catch – if your income is too high, then you cannot contribute directly to a Roth.  Specifically, if your modified adjusted gross income is greater than $122,000 for single filers or $193,000 for joint filers, then full Roth IRA contributions are not allowed.

However, this is where some good financial planning can pay off. For those high-income earners, there is (currently) the ability to make Backdoor Roth IRA contributions.

What is a Backdoor Roth IRA?

Backdoor Roth IRA contributions are a way for high income earners to make Roth IRA contributions despite being above the Roth IRA income limit.

There are no income limitations on non-deductible IRA contributions (after-tax IRAs). Additionally, there are no income limitations on converting IRAs to Roth.

As such, a Backdoor Roth involves you first making a non-deductible (i.e., after-tax) IRA contribution.   Secondly, you convert your non-deductible (i.e., after-tax) IRA to a Roth IRA.  In a pre-tax IRA conversion, you’d pay ordinary income tax on the amount converted to Roth.  However, in a Backdoor Roth, you’re converting non-deductible (after-tax) dollars to Roth, so there is no tax as a result of the Backdoor conversion.

So, instead of a one-step process by simply making a Roth IRA contribution of $6,000 in 2019, a Backdoor Roth IRA contribution requires just two steps as detailed above.

As we stated previously in this post, IRS does place income limits on Roth IRA contributions. While Backdoor Roth IRA contributions are currently a way around those income limits, it does not mean that IRS will continue to make these contributions permissible in the future.

One final note of importance. If you currently have a balance in a Traditional IRA, SEP IRA, or SIMPLE IRA, then the Backdoor Roth IRA strategy can cause tax issues due to the IRA Aggregation Rule.

The IRA Aggregation Rule requires all IRA assets to be aggregated together to determine the tax consequences of any distribution from them. So, for example, if you have an IRA and a SEP IRA, any distribution (or Back Door Roth conversion) from the IRA will aggregate the assets in the SEP IRA and use a pro-rata formula to determine the taxability of the conversion. If this is the case and you still wish to make a Backdoor Roth IRA contribution, there are ways to plan around the IRA Aggregation Rule.

Specifically, you can either convert the pre-tax IRA money to Roth and pay the tax.  Otherwise, if your employer allows you roll pre-tax IRA money into your 401k or 403b, you can roll over the balance of the Traditional IRA, SEP IRA, or SIMPLE IRA into your company (or self-employed) 401k plan in advance of making the Backdoor Roth IRA contribution. Assets held in 401k/403b plans are not subject to IRA Aggregation Rule.

The framework of establishing and implementing a Backdoor Roth IRA strategy is complex. You should always consult your tax or financial advisor prior to implementation. If you would like more details on Backdoor Roth IRAs, please contact our office.

Disclosure: This article is meant as general education on Backdoor Roth IRAs and does not equate to an endorsement of any particular strategy. You should always consult your tax and financial advisor prior to implementing a Backdoor Roth IRA strategy. Backdoor Roth IRA contributions require additional tax filing, so please keep your tax preparer informed.