One of the great challenges for those of us with significant income is not squandering our wealth. When earnings first go up, the freedom to spend becomes almost too enticing. Big-ticket items like houses and cars create the illusion of asset wealth, all while spreading your money dangerously thin. And, throughout it all, income limits and tax brackets are working against you.
With deductions and tax-advantage accounts, the average worker gets plenty of incentive to save for retirement. Once you step out of average and start earning six or seven figures, the IRS reverses course on the incentivization. In an effort to keep those with wealth from having an unfair advantage, the powers that be make it pretty difficult to save without paying heavy taxes.
If your goals for retirement and your comfortable income seem to be at odds with one another, the backdoor Roth IRA could be just the solution you’re looking for. Income limits try to ensure taxes are paid at every turn, but a simple bait and switch through a regular account provider can ensure you have one of the most valuable wealth growing tools available.
The merits of traditional and Roth IRAs can be argued at length, as both provide excellent opportunities for your wealth to grow. However, the after-tax contributions that go into a Roth get to grow without penalty, and can be withdrawn after the age of 59 ½ without incurring a tax.
However, 2020 Roth income limits have been set at a modified adjusted gross income of $206,000 for joint filers and $139,000 for individuals. Your salary doesn’t even have to creep that far into the six figures before the IRS cuts you off from the benefits of a Roth. This means most physicians, lawyers, athletes and numerous small business owners have strict limitations in how they can approach tax advantages for retirement.
Fortunately, a workaround exists for those wanting to put in a little extra effort to ensure they can take advantage of this earning potential. While direct contributions to a Roth may be off the table, the opportunity to fund and convert another account remains. Conversions are entirely legal and traditional IRAs don’t have income limits. If you know the rules and understand the steps that have to be taken, you can max out a Roth account every year even as your annual earnings continue to soar.
Jumping through the hoops can cause confusion, and some people deal with more red tape than others, but the general practice of contributing and converting at the beginning of each year isn’t that hard. A step-by-step guide will provide a blueprint for how to get it done, though each financial institution will likely have little discrepancies you’ll need to be aware of as you go through the process.
Things to know before you start:
● No tax-deferred money in any IRA
● Contribution must be non-deductible
If you fail on either of these counts, you’ve already got egg on your face. You’re already trying to get a tax break the IRS wants kept away from you, so any rule-breaking will lead to a swift slap on the wrist and maybe some money lost.
On the first point, there are a handful of retirement accounts that allow for deferment, and you’ll need to get those off the balance sheet. This includes traditional IRAs, SEP IRAs and SIMPLE IRAs. 401(k), 403(b) and similar accounts DO NOT count against you, so leave those in place if it would mean taking a big tax hit to convert them.
Should you have a few tax-deferred accounts with low balances, the smart long-term move might be to roll those into Roth accounts and take the tax hit. If the accounts don’t constitute your main retirement savings, whatever you pay in taxes will hopefully be dwarfed by the tax-free growth and distribution once you start withdrawing from your Roth account in retirement.
If you have a traditional IRA full of money that has yet to be taxed, you might have to get creative or give up on the backdoor transfer. One option would be to roll your account into an employer-sponsored 401(k), assuming that rollovers are allowed and the account is run by reputable brokers. If you have this option, you can move forward with backdoor funding without tripping any IRS alarms.
If you don’t have the option of a 401(k) through your company, another possibility for rerouting your tax-deferred money is to earn a little bit of 1099-Misc money and then open an individual or solo 401(k). You become a technical business owner with just a little bit of independent contractor earnings, and it’s likely worth the effort if it affords you the opportunity to put money in a Roth.
With the opening hurdles cleared, you can begin the process of opening your account. I’ll describe this generically; remember that your particular provider might have different steps in their process.
In theory, there are only two pieces of business required to accomplish this task:
Perhaps you already have one, but chances are you’ll need to start here. This is the entry point for Roth contributions despite earnings that supposedly preclude you from having said Roth. If you’re doing this online, it should be one of the easiest options. Ideally, you already have a money market or investment account with this same provider, making it fast and easy to provide the needed funding.
You’ll select a traditional IRA and indicate where you’d like to pull the money from, and that’s more or less the first step. You shouldn’t get any pushback, you just need to make sure you have all the right boxes checked. Depending on who you are and the site you use, it’s possible you’ll have to deal with a waiting period for the funds to process. I’ve talked to multiple people using the same service, and some have instant access while others have to sit on their hands for a week. As long as you get your confirmation email, there’s no need to panic; just try not to be too annoyed.
Hopefully, the account you open is one that will stay open even without funding. I know Vanguard allows for this, as do a number of other banks and financiers. It saves some time and makes your balance sheet look far better if you don’t have to open and close a traditional IRA every single year. You might want to call or chat with a help specialist to ensure this before you open the account.
In years past, people would wait as long as a year before ushering their traditional IRA through the backdoor to make it a Roth. The thinking was that too hasty a transaction would draw IRS attention and cause trouble. Most people don’t wait anymore, especially since a 2018 law saw Congress officially sign off on the very steps I’m describing in this article. Directly funding a Roth IRA when you make too much money might be prohibited, but this very simple loophole is perfectly legal!
In order to transfer your money, you’ll first need to open a Roth account if you don’t already have one. With the proper channels open, you’ll go into your traditional IRA and find the option to convert to a Roth. It should be one of the first choices available on your drop-down menu.
An important step that can’t be overlooked: make sure to select the right tax year. If you’re doing this conversion in the first quarter, a lot of software will default to the previous tax year. Now, anyone who didn’t fund their Roth in 2019 actually has the opportunity to make up for it now. As long as you fund and roll the money over before April, you can make this year and last year’s contributions through the backdoor.
With the year selected, you indicate where the money is coming from and where it’s going to. If you have a mutual fund Roth, the screen will look a little different than with a standard brokerage account. If you have questions about how to allocate the money, find an investor or advisor you trust and get some guidance.
Before you can initiate the conversion, you’ll see a notice that this is a taxable event and cannot be undone. While it’s true that you can’t change your mind and reverse the transaction, you don’t have to worry about the tax notification. If given the option, don’t withhold any money for federal taxes. Just move right along and select that final “complete transaction” tab.
The last step is to fill out the appropriate 8606 form. You have to declare both the non-deductible funding and the conversion to a Roth. This part feels minor and forgettable, but it’s important you keep everything on the up and up come tax time.
The actual function of the backdoor Roth conversion is fairly easy. The hard part about this process is understanding the rules and sidestepping the financial landmines.
The biggest headache comes by way of the pro-rata rule. This stipulation makes math your enemy, forcing you to determine the percentage of the money converted relative to the rest of the funds in your tax-deferred IRA. This is the means by which the IRS determines your tax burden should your transfer include anything other than non-deferred funds. Compounding the problem, the aggregation rule states that all the money in all your traditional IRAs will be viewed as one singular account.
This is where the math gets brutal. Even if you’re just converting $6,000, the maximum allotment for this year, and you make a non-deductible contribution that should be tax-free, you still have to divide that $6,000 by the total amount of money in all your tax-deferred IRAs to establish your taxable income percentage. If the $6,000 is your only non-deductible contribution and you have another $60,000 in deferred funds, only 10% of your conversion will avoid income tax. The remaining $5,400 will be subject to IRS pillaging.
This is why people either skip the backdoor Roth altogether or go through the trouble of earning 1099 payments in order to start a business and open a solo 401(k). As useful as the tax advantages in a Roth account are, it’s not worth paying income taxes on tax-deferred contributions you’ve been making for years. Better to let that money continue growing and working and then deal with taxes once you retire.
At this point, you might be thinking about how much of a hassle it would be to open a 401(k) and move a bunch of money around just to start funding a Roth account. Again, the backdoor process isn’t for everyone and it might not be in the cards for you. However, here are a few reasons why people are willing to go to such great lengths to spin their savings into a Roth IRA.
● No required minimum distributions
● No impact on social security
● Unaffected by retirement tax bracket
With most retirement accounts, you have no choice but to start pulling money out when you reach 70 ½. For those who have amassed enough wealth and perhaps still have income, it would be far more beneficial to leave that money where it is and allow the growth to continue. A Roth allows you to take distributions or leave your money right where it is. That way you stay in control and even have the option to pass the funds along to children or grandchildren.
Regarding social security, the IRS looks at your provisional income when determining how much of your social security earnings are subject to income tax. If you have enough money coming in, federal income taxes might be pulled from up to 85% of your social security check. While tax-deferred retirement distributions count as provisional income, money from your Roth does not. This means double the tax savings - no tax payments on your Roth IRA withdrawals, and lower tax fees on your social security payments.
Lastly, anyone expecting to be in a high tax bracket in retirement will absolutely want money in a Roth IRA. If you open a traditional IRA as a young professional in your 20s and fill it with tax-deferred earnings for the next four decades, you’re going to have a lot of money that still needs to be taxed when you leave the workforce. While the deductions and growth have certain benefits in the moment, it’s going to sting a lot when you withdraw funds and have them subjected to a tax rate in line with your wealth.
The benefits of a Roth IRA are pretty obvious, which is why the IRS makes it a little trickier for people in high-income brackets to use these accounts. Fortunately, the backdoor Roth conversion is perfectly legal and available to anyone with the tools to make it happen.