Recently several tax-oriented publications have been focused a bit on what is called a back door Roth IRA contribution. The reason they call it that is that it is an indirect way to contribute to a Roth IRA when you are not eligible to contribute directly to one due to high income. Those income limits for 2019 are:
Married filing jointly – you are phased out of contributing from $193,000 to $203,000 in modified AGI
Single – you are phased out from $122,000 to $137,000 in modified adjusted gross income
(This phase out range for contributing to a Roth directly will change each year).
So, how do you get around this limitation?
Here’s how it’s done: Taxpayer creates a non-deductible IRA and contributes to it. There are no income limits to do this. They may be a participant of another retirement plan and possibly couldn’t deduct an IRA contribution anyway so they create this non-deductible IRA account. After they make their contribution they convert it to a Roth IRA in the same tax year. Because this is a conversion and not a contribution to the Roth there are no income limits. The time period of waiting to do the conversion after the contribution is up for interpretation – some would say you could do it right away, some would say wait three months…there are multiple opinions.
Converting pre-tax IRA money to a Roth would normally create a tax on income that you never paid tax on, but in this case you had paid tax on the non-deductible IRA contribution – already-taxed cash was contributed. The only tax owed in this case should be on whatever the non-deductible IRA earned between contribution and conversion, which would not be much (maybe none if you never invested the money). By doing this the taxpayer made a contribution to a Roth (that they may not have ordinarily been able to do) by going through the “back door”.
Seems pretty simple, doesn’t it? Well, there are some rules around this regarding other pre-tax IRAs you may have. That would include Traditional IRAs, SEP IRAs and SIMPLE IRAs. When you do this seemingly tax-free conversion you have to add up any and all IRAs owned by you and you would be converting a portion of the whole amount. Since you have some pre-tax money and some after-tax money in that tax calculation you are converting some pre-tax and some after-tax money (even though you literally only “converted” the after-tax account). So there would be some tax owing. It may still be worth it depending on how much pre- and post-tax monies you have saved. So without question – seek the advice of your tax advisor before doing this. If all you have is 401(k) money and no other pre-tax IRAs, you may be good to go.
And as always, this does not constitute legal or tax advice – please reach out to your legal advisors before executing any tax strategy.
The views or opinions in this article are those of the author and do not necessarily represent the views of Washington Trust Bank or senior management. Washington Trust Bank believes that the information used in this blog was obtained from reliable sources, but we do not guarantee its accuracy. Neither the information nor any opinions expressed constitutes a solicitation for business or a recommendation of the purchase or sale of securities or commodities.
As Vice President and Senior Wealth Advisor, Greg provides financial analysis to high net worth individuals. He is the author of several articles for various publications and nonprofit organizations on estate and financial planning subjects.