Whenever I talk to a high-earner who wants to know what their financial priorities should be my response is always the same — max out your 401(k) to the full IRS limit ($18k in 2017) and max your Roth IRA.
With surprising frequency, I am met with the protest, “I make too much money to contribute to a Roth IRA.” Some people are aware of the fact there is an income limit on making Roth IRA contributions, with phase-outs starting at $118k MAGI for singles and $186k for married couples as of 2017. But fewer seem to be aware of the fact that in 2010 Congress changed the rules so that taxpayers at any income level can contribute by doing a so-called “backdoor Roth conversion.”
Lest you fear the term “backdoor” imply something nefarious, I assure you it doesn’t. Those congress-critters that voted on this change had plenty of self-interest motivating them. In fact, most of them take advantage of this provision, and so should you! While rumors pop up now and then that this provision may be altered in the future, such changes would not be retroactive, and should not be a deterrent to maximizing your tax-advantaged holdings today.
To illustrate the value of Roth contributions, here’s an example, with all numbers in 2017 dollars using a real rate of return of 5% — if you put the IRS max of $5,500/year into a Roth IRA for 30 years you would end up with $384k from your $165k of contributions, a gain of $219k from which you can withdraw completely tax-free in retirement! (Or you can allow it to continue to grow - Roth IRAs make a great inheritance vehicle.) And even before age 59 ½, the amount of your principal contributions can be access tax and penalty-free at any time, so you don’t sacrifice liquidity as you start to save.
So what is this backdoor Roth thing?
As of the law change in 2010, while there is still an income limit on Roth IRA contributions, there is no income limit on conversions from a traditional IRA to a Roth IRA. Furthermore, there is an income limit on taking a tax deduction for contributing to a traditional IRA, there is no limit on making an after-tax (nondeductible) traditional IRA contribution.
Are there any “gotchas” I need to look out for?
There is one big caveat here. Doing a backdoor Roth IRA works best when you have no existing traditional IRAs. If you do, for example because you rolled an old 401k into an IRA, there are options that we’ll discuss in my next post on the Avoiding the Prorata Tax on Roth Conversions.
How exactly do I make a backdoor Roth IRA contribution?
Here’s how it works:
The Finance Buff has a fantastic walkthrough of how to report all of this in online tax software.
How long should I wait between making the contribution and doing the conversion?
Back when the backdoor Roth was new, there were concerns that not waiting long enough between the contribution and conversion steps might be objectionable to the IRS. While it is always possible they could decide this at some point in the future, over seven years and millions of Roth conversions they have not disallowed any for this reason. Go ahead and do your Roth conversion whenever is convenient after the traditional IRA deposit has cleared.
Is there a five-year rule on withdrawing principal from a backdoor Roth IRA since it’s a conversion?
No! If you plumb the depths of IRS Form 5329 you’ll discover that the rules restricting withdrawals of Roth IRA conversions only apply to amounts which were subject to taxes in the conversion process, which is not the case for converting a nondeductible traditional IRA.
I thought I was only supposed to contribute to a Roth IRA if I expect to be in a higher tax bracket in retirement.
When you hear that you should “contribute to a Roth if you expect to be in a higher tax bracket in retirement,” that is referencing the choice of making Roth contribution versus contributing to a traditional tax-deferred account. If you’re worried about a backdoor Roth IRA, I’m willing to bet you have an employer-sponsored retirement account and are over the income limit to deduct traditional IRA contributions.
If you are at the point where all your other tax-advantaged account are full, the calculus changes. Now your options are investing in a Roth account where you’ll never pay taxes on this money on its growth again, or investing it in a taxable account where every dividend or sale is going to siphon off bits of your money to taxes, eroding your return.
This sounds great! Is there any reason I shouldn’t do this?
With the dual benefits of tax-free growth and the flexibility of withdrawals offered by Roth IRAs, this is a no-brainer for most people. If you have high-interest debt, that should always be your first financial priority. But if you’ve for your bases covered and are looking at how to make the most of your savings for the future, get yourself a Roth IRA.