The Roth IRA is widely considered one of the greatest gifts the U.S. Congress has ever given to taxpayers. With a Roth IRA, contributions are made with after-tax dollars and, therefore, we do not receive an upfront tax deduction for the contribution. In return for not getting a tax deduction, the taxpayer gets something more significant – qualified distributions can be withdrawn tax free. Qualified distributions are distributions that occur after a five-year waiting period has elapsed and a triggering event has occurred. The triggering events are either the attainment of age 59½, death, disability, or a first time home purchase. Not only are your initial contributed amounts withdrawn tax free but all of the future appreciation in the Roth IRA account value escapes taxation as well.
One problem that has frustrated many taxpayers is the relatively low income limits which prohibit many of us from being able to contribute to a Roth IRA. For 2015, a married couple filing a joint return will be unable to contribute to a Roth IRA if their modified adjusted gross income (MAGI) exceeds $193K. For a single person, the ability to contribute to a Roth IRA account disappears when MAGI exceeds $131K.
We have been advising our clients for some time now about the strategy of contributing to a Roth IRA even when your income exceeds the above income limits. Many practitioners call this strategy a Backdoor Roth IRA Conversion. Let me explain how this works.
First, you will need to contribute funds to a traditional IRA with your IRA custodian. In order to do this, you will need to have earned income and you must not have reached 70½ years of age. You do not need to inform your custodian whether this is a deductible or nondeductible contribution – just that it is a contribution to your IRA.
For example, let’s assume you have the necessary earned income and you have not reached 70½ years of age. You contribute a maximum of $5,500 to your IRA account ($6,500 if you reached 50 years of age during the year). Once the IRA contribution posts to your account, you inform your custodian that you wish to convert these funds to a Roth IRA. Some practitioners suggest that you can do this conversion the very next day whereas others suggest you wait a short period of time. I recommend you wait until at least the next month (e.g., you fund the IRA on April 15 and call your custodian with the conversion order on May 1).
There is one big caveat. This strategy only works well for taxpayers who do not already have money in traditional IRA accounts because the IRS pro-rata rule will apply. The pro-rata rule dictates that all owned IRAs, including SEP and SIMPLE IRAs, are included in the required pro-rata calculation. For example, let’s assume you already had a traditional IRA with a value of $95K (from deductible prior year contributions plus appreciation). If you attempted this strategy with a $5,000 current year contribution, the pro-rata rule would result in a fraction of $5,000/$100,000 so that only 5% ($250) would be a tax-free conversion. The other $4,750 would be taxable income from the conversion that would be reported on your income tax return. Obviously, this is not a great result for all this work.
A better result plays out for the taxpayer who has no other IRA accounts. In this case, the entire $5,000 nondeductible contribution could be converted to a Roth IRA free of income tax. The only income that would be taxable for this taxpayer would be any appreciation on the $5,000 investment from the date of contribution to the date of conversion.
As you can see from the above examples, determining the best strategy depends on a number of factors. We would be happy to assist you in exploring this strategy if you wish to contribute money into a Roth IRA and your income exceeds the Roth IRA contribution limits.