The Backdoor to Making a Roth IRA Contribution

Here’s a little secret…there’s a backdoor.

Contributing to a Roth IRA directly is a privilege reserved for those below a certain income level. (Those darn politicians and their tax breaks for the middle class.)

The Roth IRA income limitations state that if you made over $125,000 as a single filer, or over $183,000 as a married filing jointly filer then you can’t contribute to a Roth IRA…or can you?

Roth IRA Conversions Left the Backdoor Open

Something changed in 2010 that allows those with incomes exceeding the limits above to contribute indirectly to a Roth IRA each year. What changed was the income limitations on Roth IRA conversions. Starting in 2010 you can convert a traditional IRA to a Roth IRA regardless of how much income you have. Why convert? Well, some consider the Roth IRA a better retirement vehicle since it allows tax-free growth of your investments.

So the idea now is that you,

1. contribute funds to a non-deductible traditional IRA, and then
2. convert that IRA over to a Roth IRA.

Your broker or mutual fund company should be able to handle all of this for you with a couple of phone calls. You’ll also need to keep track of your moves though for tax reporting.

An Example of the Backdoor Roth IRA Contribution

The annual contribution limit on your IRAs is $5,000. So let’s say you attempt this backdoor move and first contribute the max, $5,000, to a non-deductible traditional IRA.

This can be done fairly quickly these days. Simply send a check or bank transfer to your broker or mutual fund company and ask them to use the money to setup a non-deductible traditional IRA. Once the transaction is complete, wait a day, week, or as long as you want, then call them up again and request a conversion to a Roth IRA.

Getting Around the Pro-Rata Rule

Where this gets tricky apparently is in the conversion. When you make a conversion, you have to consider all the money in all of your traditional IRAs as being in one bucket. So, regardless of your current year non-deductible traditional IRA contributions, you may have to pay taxes on your conversion if you have ever made deductible traditional IRA contributions.

For example, let’s say I have $15,000 in a deductible traditional IRA. I made these contributions a few years back when I didn’t have access to a company 401K. Now, this year, I’ve decided to try to complete the backdoor Roth IRA.

First I’d contribute my $5,000 to the non-deductible IRA. Then I’d go to make the conversion. When I convert my $5,000 I’ll have to consider all $20,000 ($15,000 + $5,000) in the move. Since 75% of my balance is tax advantaged, I’ll have to pay taxes on 75% of my conversion. So, $3,750 of my current year conversion will be taxed as income.

This requirement on the conversion makes the decision a bit tougher for people who already have traditional IRA account balances. But according to Forbes.com there is a way around this “pro-rata” rule.

“So how do you remove the pretax IRA from the equation? Transfer it to a 401K. Many employer plans allow “roll-ins” of IRA money to 401Ks.”

Ah, sneaky, sneaky. I actually just opened a solo 401K with Vanguard so I may look into doing one of these roll-ins with my old traditional IRA, even if a backdoor Roth IRA contribution isn’t in my future.

More reading: Dodging The Income Limits on Roth Contributions – Strategy Or Abuse?

What about you, have you been doing these backdoor Roth IRA conversions the past couple of years? Do you see it as something you’ll use in the next couple of years?

Image by Marco Bellucci