In 2015, you are not allowed to make full contributions to your Roth IRA if your Modified Adjusted Gross Income (MAGI) is over $183,000 and you are not allowed to make any contribution if MAGI is over $193,000.
However, you may still be able to add funds to your Roth IRA with what is called a backdoor Roth.
Although with a high income you cannot receive a deduction for traditional IRA contributions, you are still allowed to contribute to a nondeductible IRA. Your contribution is put in after taxes.
When nondeductible IRAs are converted into Roth IRAs, only the earnings portion is taxed. The rest, because it was taxed on the way in, is converted free of tax.
As a result, assuming that you have no other traditional IRA assets, the money you convert from your newly funded nondeductible IRA will not be taxed.
If you have any other IRA money, the IRS looks at all of the assets when calculating your conversion tax. Rather than tracking the precise dollars to see that these are nondeductible IRA dollars, they blend all the IRAs together and tax you the pro-rata amount which has not been taxed.
For example, if you have $95,000 of traditional IRA assets and you make a $5,000 non-deductible IRA contribution, then any conversion would be 95% taxable.
But if you have no traditional IRA assets then none of the subsequent conversion would be taxable. This is how a backdoor Roth is equivalent on your taxes to funding your Roth IRA in the first place.
A backdoor Roth is most appropriate after you have converted all of your traditional IRAs to Roth accounts. Then, you can continue to make the equivalent of Roth contributions through non-deductible IRA contributions and immediate Roth conversions.
For this reason, Roth conversions are sometimes still a good idea for higher income earners. Once all your traditional IRAs have been converted to Roth IRAs you can continue to fund your Roth account via a backdoor Roth each year. And a backdoor Roth is equivalent to moving money from your taxable account into a Roth where it will never be taxed again.
The balances of traditional 401(k) and 403(b) accounts do not affect a backdoor Roth contribution, but traditional IRA accounts do. This provides an alternate method of divesting yourself of traditional IRA assets.
Many 401(k) and 403(b) plans allow you to roll traditional IRA assets into the plan. This allows you to move all of the pretax dollars from your IRA accounts into your employer-sponsored plan where they don’t affect your backdoor Roth.
Another benefit to a 401(k) roll in is that 401(k)s are only subject to required minimum distributions after the employee has retired and does not own 5% or more of the company.
A 401(k) roll in is best done with a direct custodian to custodian transfer. If you receive a personal check, you will have 60 days to redeposit the check into your 401(k) account. If the custodian of your traditional IRA incorrectly withheld some percentage for state and federal taxes, it may be difficult to come up with the full amount of the money you need to deposit. Finally, there is always the small chance that you were misinformed and the transfer won’t work.
A custodian-to-custodian transfer helps ensure that if the transfer doesn’t work, the funds simply stay in the traditional IRA as though nothing has happened.
After you have divested yourself of any pre-tax IRA assets, funding a backdoor Roth is simple.
First, make a non-deductible contribution to your traditional IRA, keeping the assets in cash while it is in your traditional IRA. Keeping the contribution in cash and converting relatively quickly executes the conversion before any interest is paid in the traditional IRA. If interest is paid, this small growth in the account will be taxable when the assets are converted.
Second, convert the nondeductible IRA to your Roth IRA.
For those in the upper incomes, a $5,500 or $6,500 contribution may not seem like it will make a big difference, but it will. When you add up even one individual’s contributions and growth across a decade, it can easily amount to over a million dollars protected from taxes in a Roth account. If husband and wife both make contributions, that amount could be doubled.
Some wealthy families are worried that the tax advantages of Roth IRAs will be eliminated by a Congress aiming for those in the upper incomes and bent on burdening the wealthy with even more taxes. While this is possible, the proposals which have been formulated suggest that politicians would be more likely to make it more difficult for the wealthy to get money into a Roth IRA and may eliminate the ability to do a backdoor Roth contribution.
Such suggestions currently have little chance of passing a divided Congress. If anything though, you should utilize this strategy to get your Roth accounts grandfathered before the opportunity for additional contributions closes.
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