Contributing to a Roth IRA through a Backdoor Option

Many high income earners believe they cannot contribute to a Roth IRA because of the income limitations imposed by the Internal Revenue Service (IRS).  There is a backdoor route high income earners can take, however, to accomplish the same thing as opening a Roth IRA directly.

For 2014, the income and contribution limits for a Roth IRA are as follows:

Filing Status ModifiedAdjusted Gross Income ContributionLimit
Married, Filing Jointly ˂ $181,000 Up to the limit*
≥ $181,000, but less than $191,000 Phased Out Amount
≥$191,000, eligible Ineligible
Married, Filing Separately ˂$10,000 A reduced amount
≥10,000 Ineligible to contribute
Single ˂$114,000 Up to the limit*
≥$114,000, but less than $129,000 Phased Out Amount
≥$129,000 Ineligible to Contribute

* The limit on contributions for 2014 for all traditional and Roth IRAs is $5,500.00 ($6,500.00 if age 50 or older).

Despite the flurry of recent tax legislation, the income limits have remained in place for contributions to a Roth IRA.  However, for conversions from a Traditional IRA to a Roth IRA, the Tax Relief Unemployment Insurance Reauthorization and Job Creation Act of 2010 has removed these income limits, creating a backdoor for interested investors to utilize.  To contribute to a Roth IRA through the backdoor, follow these steps:

Step 1 – Consult with a tax advisor to determine whether a Roth IRA is an appropriate retirement vehicle for you.  

Step 2 – Contribute to a non-deductible, Traditional IRA up to the contribution limit. 

  • Your contribution will most likely be non-deductible given the income limits, however, contributions to a Roth IRA are not tax deductible anyway.
  • Your contribution will be your “cost basis” for tax purposes.

Step 3 – Convert your Traditional IRA to a Roth IRA.  

  • This process will be much easier if both your Traditional IRA and Roth IRA are held with the same custodian, and if the deposit to the Traditional IRA and the conversion to a Roth IRA, are part of one seamless transaction.
  • Do not confuse a conversion with a distribution, the latter of which will subject you to a 10% penalty if under age 59 ½.
  • The amount of the conversion will be limited to the $5,500.00 (or $6,500.00, if over age 50) assuming that a new Traditional IRA is being opened just for this purpose.
  • For those with an existing Traditional IRA, the limit will be the balance of the account.  Keep in mind, however, that the amount of the conversion will have to be reported as ordinary income, so it may be best to convert smaller portions of anexisting Traditional IRA over a number of years.
  • In determining whether it would be better to convert smaller portions of a Traditional IRA over a number of years, consideration should be given to whether the amount of the conversion will result in a bump up to a higher tax bracket.
  • More likely than not, if requested, your custodian will leave one penny in your Traditional IRA account so that this process can be repeated every year.  (Be sure to ask if interested.)

Step 4 – Make note of any income tax due as a result of the conversion to the Roth IRA.  

  • The income tax due will be zero or close to zero if the non-deductible deposit into the Traditional IRA is followed by an immediate conversion into a Roth IRA.
  • If the conversion results in a higher tax bracket, or more income tax due than the budget allows, then work with your custodian to reverse the process.

Step 5 – Notify the Internal Revenue Service.  

Make sure that IRS Form 8606 is filed with the income tax return for each year that a backdoor Roth IRA contribution is made, in order to alert the IRS that the deposit into the Traditional IRA is non-deductible.  This will also help maintain records of the cost basis.

Roth 401(k) Plans Offered through Employer 

For those who have access to a Roth 401(k) Plan through work, this could be a viable alternative, or addition, to the Roth IRA.  A Roth 401(k) has no income limit, but for 2014, the contribution limit is the same as for a regular 401(k): $17,500 ($23,000 if age 50 or over).  Contributions can be made to both a Roth 401(k) and a regular 401(k) in the same year, so long as the contribution does not exceed the $17,500/$23,000 limit.

The most noteworthy distinction between a Roth IRA and a Roth 401(k) is that the Roth 401(k) is subject to the same minimum distribution rules as a traditional or regular 401(k) require.  Of the three vehicles, the Roth IRA offers the most flexibility in retirement, although contributions are more difficult during the accumulation years for high income earners. The following chart may provide assistance in determining whether a Roth IRA, Roth 401(k), or a traditional or regular 401(k) is the best option for your particular situation:

 Designated Roth 401(k) Account  Roth IRA  Traditional, Pre-Tax 401(k) Account
 Contributions Designated Roth employee elective contributions are made with after-tax dollars. Roth IRA contributions are made with after-tax dollars. Traditional, pre-tax employee elective contributions are made with before-tax dollars.
 Income Limits No income limitation to participate. Income limitation for 2014:

  • Modified AGI married $191,000/single $129,000
No income limitation to participate.
 Maximum Elective Contribution $17,500 for 2014, plus an additional $5,500 for employees age 50 or over. $5,500 for 2014, plus an additional $1,000 for employees age 50 or over. Same aggregate limit as Designated Roth 401(k) Account
 Taxation of Withdrawals Withdrawals of contributions and earnings are not taxed provided it’s a qualified distribution (the account is held for at least 5 years) and made:

  • On account of disability,
  • On or after death, or
  • On or after attainment of age 59½.
Same as Designated Roth 401(k) Account and can have a qualified distribution for a first time home purchase.  Note:·          Contributions may be withdrawn without tax or penalty at any time.·          Conversions may be withdrawn without tax, (and without penalty, but only if held for 5 years). Withdrawals of contributions and earnings are subject to Federal and most State income taxes.
 Required Distributions Distributions must begin no later than age 70½, unless still working and not a 5% owner. No requirement to start taking distributions while owner is alive. Same as Designated Roth 401(k) Account.
* Source:  Internal Revenue Service.  This article is not intended to provide tax advice.  A tax advisor should be consulted when making a contribution, conversion or withdrawal from any retirement vehicle.

Linda Davis Friedland is an attorney in our Livonia office where she concentrates her practice on commercial litigation, employment and labor law, corporate and business law, estate planning, utilities Law and municipal Law. She may be reached at (734) 261-2400 or lfriedland@cmda-law.com.