Your ability to contribute to a Roth IRA or receive a deduction for traditional IRA contributions is restricted as your income goes beyond a certain threshold. However regardless of your income level, you are still allowed to make a nondeductible contribution to your traditional IRA. Making a nondeductible contribution to your traditional IRA and then converting it to a Roth IRA is known as a “backdoor Roth” because if you do it correctly 100% of your Roth conversion will be after-tax and thus not taxable.
However, if you already have a pre-tax traditional IRA balance, each distribution or conversion is taxed pro-rata after-tax and pre-tax based on the size of your IRAs and the size of your nondeductible basis. This complicates the backdoor Roth strategy, although its benefits still remain for many.
For taxpayers who are currently eligible to contribute to a Roth IRA through normal means, increases in modified adjusted gross income (MAGI) could push them over contribution phase-out thresholds and require them to use the backdoor Roth strategy to contribute.
Here are three common Roth transactions and how they interact with MAGI for Roth IRA purposes.
What is MAGI?
Based on Worksheet 2-1. Modified Adjusted Gross Income for Roth IRA Purposes , your MAGI is calculated as your adjusted gross income (AGI) (1040 Line 11) minus “any income resulting from the conversion of an IRA (other than a Roth IRA) to a Roth IRA (included on Form 1040, 1040-SR, or 1040-NR, line 4b) and a rollover from a qualified retirement plan to a Roth IRA (included on Form 1040, 1040-SR, or 1040-NR, line 5b)” and then plus a series of other items.
- any income resulting from the conversion of an IRA (other than a Roth IRA) to a Roth IRA (included on Form 1040 line 4b)
- a rollover from a qualified retirement plan to a Roth IRA (included on Form 1040 line 5b)
- any traditional IRA deduction
- any student loan interest deduction
- any foreign earned income exclusion and/or housing exclusion
- any excludable qualified savings bond interest
- any excluded employer-provided adoption benefits
Roth Conversion to Roth IRA is excluded from MAGI.
The MAGI formula starts by subtracting Roth conversions to a Roth IRA. This is why we have written previously how large Roth conversions do not require backdoor Roth contributions.
In-Plan Roth Conversions are included in MAGI.
Roth conversions outside of a Roth IRA are included in MAGI. This means that a Roth conversion which occurs within your employer sponsored retirement plan will affect your MAGI for Roth IRA purposes. Those are Roth conversions inside accounts such as a 401(k), 403(b), or 457 plan.
These types of conversions are sometimes called in-plan Roth conversions because they move funds from a traditional component into a Roth component all within your 401(k) plan.
Roth Deferrals are included in MAGI.
While all employers offering defined contribution plans permit pre-tax employee deferrals, some employers also permit Roth employee deferrals. Pre-tax traditional employee deferrals reduce your AGI, but Roth employee deferrals count as wages in the year of contribution.
Regardless of which election you make, your ability to defer some of your income to an employer plan is not limited by your income. Unlike Roth IRA contributions, there are no MAGI limits for Roth employee deferrals.
However, Roth employee deferrals are included in your MAGI and affect your MAGI for Roth IRA contribution purposes. While traditional deferrals reduce your MAGI, Roth deferrals keep it the same.
How to Work Around This
If you have no traditional IRA balances, then there really is nothing that needs to change. You can simply do a backdoor Roth IRA contribution, make sure it is reported correctly on your tax return, and move on. A backdoor Roth IRA contribution is identical to a regular Roth IRA contribution when no other traditional IRA balances are present.
If you have other traditional IRA balances, then one option is to remove them. If your employer plan accepts outside funds, you can do a reverse rollover of your traditional IRA balances into your 401(k) plan. This leaves behind only your nondeductible basis and gives you a clean slate to perform the backdoor Roth strategy.
Another option is that you can reduce your MAGI for Roth IRA purposes by doing your Roth conversion from your 401(k) to your Roth IRA instead of an in-plan conversion. Those over age 59 1/2 are typically eligible for in-service rollover Roth conversions from all 401(k) balances whereas younger employees are typically eligible to rollover certain vested balances such as profit sharing. By transferring the traditional 401(k) assets to a Roth IRA, instead of a Roth 401(k), you may be able to reduce your MAGI for Roth IRA purposes below the phase-out thresholds.
If you are eligible for rollover conversions of your traditional 401(k) deferrals, you could even reduce your MAGI further by making traditional employee deferrals to your 401(k) and then doing a rollover Roth conversion to your Roth IRA for something resembling a backdoor Roth deferral.
Regardless of what you do, bias yourself to getting more money in Roth accounts. Most people benefit from funding their Roth even when they cannot afford it and benefit from starting conversions now without delay.
Photo by Demi DeHerrera on Unsplash. Image has been cropped.