Many high earners, including Tiger Woods, are ineligible to fund a Roth IRA directly. But when the front door is locked, why not try the back door? A backdoor Roth IRA contribution requires some extra steps but allows high-income earners equal access to the tax-free benefits of a Roth IRA.
This year, married couples filing their taxes jointly begin to lose eligibility to contribute directly to a Roth IRA when their modified adjusted gross income (MAGI) reaches $178,000. The phaseout range for individuals is $112,000 to $127,000. If your income makes you eligible, you can open a Roth directly.
Steps for the backdoor method take more work:
1. Make a nondeductible contribution to a traditional IRA (TIRA). These accounts impose no income limit for contributions but you do not get to deduct the contribution against your income. Even the highest-paid athlete (golf megastar Tiger Woods according to Forbes, who last year putted his way to $78.1 million), you can make a $5,500 contribution for 2013. Those 50 or older can add another $1,000 for a total contribution of $6,500.
2. Convert the traditional IRA to a Roth IRA. When your TIRA contribution posts, you can then convert these funds to a Roth IRA. Because you initially invested with after-tax dollars, the conversion incurs no taxes. You now have tax-free money in your Roth IRA.
3. Repeat every year. Beginning at age 50, a couple can begin saving $13,000 every year and move $130,000 into a Roth IRA over the next 10 years where it will never be taxed again.
If you had left this $13,000 in a nonqualified taxable investment account or a savings account, your interest and dividends suffer taxes every year. Those 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 able to use this method to move $13,000 annually will save a bundle. At a 2% growth rate, this tax savings top $4,861 over a 10 years. An 8% growth rate produces tax savings exceeding $25,856.
One big caveat to the tax-free nature of this Roth conversion: You realize full benefits only if you own no other pretax IRAs. Any other IRA retirement accounts, including SEPs or Simple IRAs, ignites taxes on a portion of your conversion. Even if your TIRA contains only nondeductible contributions, the Internal Revenue Service taxes the percentage of your pretax IRA assets to total IRA assets.
For example, Norm and Nancy are married, and Norm has the only IRA account funded fully with pretax dollars. Both make $6,500 nondeductible contributions to their IRAs that are immediately converted.
Norm’s conversion creates $6,175 of taxable income; Nancy’s conversion will be tax free. Norm’s tax resulted from 95% of his IRA assets ($95,000/$100,000) are pretax. Nancy’s conversion is tax free because she does not own any other pretax IRA assets.
IRA rules apply on the individual level in the case of a married couple. If only Nancy makes a conversion, Norm’s pretax IRA assets do not apply to the pro rata tax formula.
To avoid this pro rata rule, Norm can transfer his $95,000 pretax IRA assets into a 401(k) plan. Assets in a 401(k), 403(b), 457, or a Thrift Savings Plan are not counted when applying the pro rata taxation rules. Alternatively, he could convert the entire IRA in 2013, pay tax based on the pro rate formula, and free himself up to make a tax-free conversion in 2014 and beyond. In either case, you need to clear out your IRAs to reap the full benefits of a back door Roth.
You can readily see that when it comes to tax planning, a few extra steps can make your retirement years a little more golden.