This article has been updated with new tax thresholds for 2013 and can be found here.
Q: I am over the income limits to contribute to a Roth IRA and already maxing out my 401(k). Where do you recommend that I save an additional $10,000?
Sincerely, Ima Squirrel
$ ?s answered by Matthew Illian, CFP®
Although we still do not know what the tax changes will look like, we know hikes are coming for high-income earners. Roth IRAs provide a unique shelter from future taxes, but many high-income earners are disqualified from making Roth IRA contributions directly. When the front door is locked, try the back door.
For 2012, the adjusted gross income (AGI) phase-out range for Roth IRA contributions is $173,000 to $183,000 for married couples and $110,000 to $125,000 for individual taxpayers. When your AGI is over these amounts, you are not eligible to contribute to a Roth IRA. If you are unsure of your AGI, look at the last line (37) on the first page of your 2011 tax return as an estimate.
There is a backdoor way to contribute to a Roth IRA for those who are not income eligible. This method requires the following steps:
- Make a nondeductible contribution to a traditional IRA (TIRA). There is no income limit for those who wish to make a nondeductible contribution to a TIRA. As long as you report an income, even if you’re the highest paid sports athlete (according to Forbes, this award goes to Floyd Mayweather’s 2011 income of $85 million), you can make a $5,000 contribution. Those age 50 or older can add an additional $1,000 for a total contribution of $6,000.
- Convert the traditional IRA to a Roth IRA. As soon as your contribution posts, you can then convert these funds to a Roth IRA. Because the contribution was initially invested with after-tax dollars, this is not a taxable event. You now have tax-free money in your Roth IRA.
- Repeat every year. By saving $10,000 a year, a couple can move $100,000 into a Roth IRA over the next 10 years where it will never be taxed again.
Let’s review what just happened. If you had left this $10,000 in a nonqualified taxable investment account or a savings account, your interest and/or dividends would be taxed every year. Some people in the highest income tax brackets will see these tax rates approach or exceed 50% when they include their state and local tax burden. A high-income couple who is able to use this method to move $10,000 will save a bundle. If we assume a 2% growth rate, this tax savings will be $5,919 over a 10 year period, and if we assume an 8% growth rate, this tax savings will be $31,115.
There is one big caveat to the tax-free nature of this Roth conversion. You only get the full benefits of a tax-free transfer if you own no other pretax IRAs. Any other IRA retirement accounts, including SEPs or Simple IRAs, will cause a portion of your conversion to be taxed. Even if your TIRA only has nondeductible contributions in it, the IRS will count the percentage of your pretax IRA assets to total IRA assets as taxable.
For example, assume with me that Roy and Pam are married and Roy is the only one with an IRA account funded fully with pretax dollars. If both make $5,000 non-deductible contributions to their IRAs which are immediately converted, Roy will have created $4,750 of conversion income, but Pam’s conversion will be tax free. Roy’s tax is created because 95% of his IRA assets ($95,000/$100,000) are pretax. Pam’s conversion is tax free because she does not own any other pretax IRA assets. You can see that in the case of a married couple, IRA rules apply on the individual level. If Pam was the only one making a conversion, Roy’s pretax IRA assets would not apply to the pro rata tax formula.
One way for Roy to avoid this pro rata rule is to transfer his $95,000 pretax IRA assets into a 401(k) plan. Assets in a 401(k), 403(b), 457, or Thrift Savings Plan are not counted when applying the pro rata taxation rules.
The other strategy is to go ahead and convert the entire IRA in 2012. Many high-income earners are better off paying the maximum federal tax rate of 35% than they would be if they delay. In either strategy, you need to clear out your IRAs to reap the benefits of a backdoor Roth.
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