The “Backdoor” Roth IRA Strategy for High Income Earners

The “Backdoor” Roth IRA Strategy for High Income Earners

Roth IRAs have a great tax appeal to many Americans, but ironically “high income earners” are disqualified from making annual contributions. However, there is a backdoor that would allow literally anyone, irrespective of income, to fund a Roth IRA.

But before we get down to the nitty-gritty, let’s get a couple of key points straight.

First, by IRS definition, in 2013 you are considered a high earner and therefore disqualified from contributing the annual sum of $5,500 or $6,500 if you’re age 50+ to a Roth IRA if you and your spouse file jointly with a modified adjusted gross income (MAGI) of $188,000 or more. Or if you’re single with a MAGI of $127,000+. Of course, many folks – especially couples – may disagree with the “higher earner” designation, but the IRS has the last word so let’s leave it at that.

The second point is that this “backdoor” strategy is perfectly legitimate.

Now here’s the thing. There is no income limitation when it comes to contributing to a nondeductible traditional IRA, or for doing a Roth IRA conversion. That’s interesting, because practically anyone – even if they make a gazillion bucks a year – may do either or both. This creates – for lack of a better term – the perfect backdoor for any high earner who wants to fund a Roth IRA.

The steps are, simply:

a.       Make the allowable annual contribution to a nondeductible traditional IRA.

b.      Then, immediately (note the keyword immediately) convert the nondeductible traditional IRA to a Roth IRA.

Since nondeductible contributions create what is called a tax basis, any tax bill that results from the conversion – that’s assuming there is one – will be limited to only the growth in value between the date the traditional IRA was funded and the date the Roth conversion occurs. If a truly savvy financial adviser is in the picture, the final tax bill should be zero or something not far off.

This strategy effectively makes it possible to contribute the same amount to a Roth IRA indirectly, and most importantly do so without breaking any rules.

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