Backdoor Roth IRA Contributions
Two years ago I met with a client and she was disappointed when I informed her she could no longer make Roth IRA contributions because her income was too high. After listening to her not so flattering comment about our tax system I decided to mention how she could get around the income limit fully expecting her to say “that is too complicated forget it” but to my surprise she wanted to do it. She did ask me, “What is the point of the income limit if you can get around it?” I told her to write her representative in Congress for the answer.
I decided to write this article because I was surprised at how many of my clients were willing to follow the steps below in order to get their money into a Roth IRA. I do not discuss or compare the pros and cons of IRAs and Roth IRAs in this article but detail how individuals with high incomes who have already decided that a Roth IRA will work best for them can continue to make deposits or start a Roth IRA.
The general idea is that taxpayers make non-deductible contributions to their IRA accounts and then rollover their contribution to a Roth IRA since there is no income limit on Roth IRA rollovers. With proper planning the IRA rollover will be tax free since the non-deductible contributions will create basis in the IRA.
Betty has no retirement plans and on 01/07/X1 she opens a traditional IRA and deposits $5K. On 01/09/X1 Betty opens a Roth IRA and then instructs the banker to process a direct rollover distribution from her IRA to her new Roth IRA in the amount of $5K. Betty’s income for 20X1 is $10 million. Betty’s IRA deduction will be eliminated due to her income , therefore her IRA contribution will be non-deductible. The 1099-R she receives from the bank will indicate that the taxable amount of the $5K distribution is not determined. Betty needs to fill out a form 8606 in order to calculate the taxable amount.
Betty's taxable amount would be zero. You divide her IRA basis, $5K, by the sum of the year end value , 0, plus the amount rolled over to the Roth IRA, $5K, = 1 or 100%. Betty’s distribution from her IRA will be 100% non-taxable.
IMPORTANT: Taxpayers are allowed to make IRA contributions from January to April 15th for the prior year but non-deductible IRA contributions made during this time will not be included in the taxpayer’s basis so it is important for all non-deductible contributions to be made before December 31st.
Taxpayers who do not own any retirement accounts can simply open an IRA make a deposit of $5K then open a Roth IRA and instruct the banker to rollover the $5K from the IRA into the Roth IRA. Unlike Betty, most high income taxpayers do have retirement accounts and without proper planning could pay taxes on all or a portion of the distribution rolled over to their Roth IRA.
Any high income taxpayer wanting to make Roth IRA contributions needs to understand that the calculation used to determine the taxable amount of an IRA distribution/rollover combines all IRAs, SEP, and SIMPLE IRAs. The ratio used to calculate the taxable portion of any distribution from an IRA takes the values of all IRAs, SEP, and SIMPLE IRAs at year-end then minuses any regular distributions and adds any distributions that were rolled over to a Roth IRA. Example: Bob has two IRAs with a total value of $150K on 12/31/X1. In prior years, Bob had made non-deductible IRA contributions totaling $25K. During 20X1, Bob opened a Roth IRA and rolled over $50K from one of his IRAs. Bob also made a $5K non-deductible contribution to one of his IRAs.
The taxable amount of Bob’s $50K rollover:
IRAs basis $30,000. Current year non-deductible contribution plus prior years, $5,000 + $25,000 = $30,000
IRAs Year-end Value $200,000. Year-end value of both IRAs less any distributions plus any amounts rolled over to a Roth IRA, $150K-$0+$50K= $200K
You divide Bob’s basis of $30K by $200K = .15
Of the $50K Bob rolled over to his Roth IRA $42,500 will be taxable. $50K – ($50K x .15) = $42,500. At the end of the year Bob’s basis in his IRAs will be $22,500 ($30K-$7.5K).
How to prevent any amount being taxable:
Taxpayers whose employers offer 401K plans that allow roll ins can easily rollover all of their IRAs into the 401K plan so that future IRA and Roth IRA rollovers are tax free. The value of the taxpayers IRAs, SEP, and SIMPLE IRAs at the end of the year would be Zero, so none of their Roth IRA rollover would be taxable assuming they have enough basis. Currently, some employer offers Roth 401K where taxpayer can contribute up to $17,500. These Roth 401K plans also have no income limits. High-income taxpayers can participate in a Roth 401K as well as make these complicated Roth IRA deposits if so desired.
If you are a high income taxpayer who wants to use a Roth IRA don’t let your high income detour you, just make sure you understand the rules or use a competent tax professional to guide you through the process. Contact Gregory Fallon, EA, MST with any comments or questions.