If you are reading this, you are probably familiar with the common advice to maximize your Roth IRA contributions. But maybe you have—or will soon—run into the problem of being ineligible to contribute. Are you out of luck? Fortunately, the answer is no.
Why a Roth IRA anyway?
The primacy of maximizing your Roth IRA contributions on the path to financial freedom is for good reason. Just to recap, here are the highlights of a Roth IRA:
You make contributions with post-tax money, so there is no up-front deduction.
Your contributions grow tax-free.
Qualified distributions (whether comprising contributions, growth, or both) are also entirely tax-free!
There are no required minimum distributions from a Roth IRA, and Roth IRA beneficiaries have more options after your death than traditional IRA beneficiaries.
A qualified distribution is one that is made (1) after age 59.5 and (2) more than five years after you opened your first Roth IRA account. The ability to take entirely tax-free distributions after age 59.5 is what makes a Roth IRA a powerful piece of your retirement plan.
Another strength of the Roth IRA that appeals to those planning to retire before age 59.5 is that you can also withdraw your contributions (but not the growth) at any time—even years or decades prior to age 59.5—without taxes or penalties, since you have already paid taxes on that money.
If you withdraw the growth early, it is treated like an early distribution from a traditional IRA. You will pay taxes on the amount withdrawn, plus a 10% early-withdrawal penalty.
For example, assume you have contributed $45,000 to your Roth IRA, it is now worth $60,000, and you have not yet reached age 59.5. (Because of your age, you cannot take a “qualified distribution” regardless of how long the account has been open.) You can withdraw up to $45,000 from your Roth IRA now, and incur no taxes or penalties so long as you leave the $15,000 growth untouched. If you withdraw the entire balance, you will pay taxes on the $15,000 growth plus a 10% penalty on the taxable amount (i.e., $15,000 × 10% = $1,500). But if you withdraw only $25,000 (leaving the balance at $35,000), you pay no taxes or penalties, and your Roth IRA now comprises $20,000 in contributions plus $15,000 in growth.
Can everyone contribute to a Roth IRA?
Individuals may contribute up to $6,500 (or $7,500 if at least age 50 by the end of the year) to a Roth IRA in 2023, if they have earned income, or a spouse with earned income, of at least this amount. Any workplace retirement coverage or contributions (such as to a 401(k) plan) do not impact this limit. Age is not a limiting factor, either; if your child earns income, they can contribute to a Roth IRA!
There are two main limiting factors. First, any contributions to a traditional IRA lower your Roth IRA contribution limit, because the $6,500 / $7,500 maximum is the total amount you can contribute to all your traditional and/or Roth IRAs. (Rollovers and conversions do not count towards this limit because they are not contributions.)
The second limiting factor is income. The specifics about what counts as income is a topic for another day—follow that link if you are interested—but ultimately it boils down to this: if you make too much money, you cannot contribute to a Roth IRA. How much is too much?
Single or head of household = $153,000 or more
Also included married filing separate, if the taxpayer did not live with their spouse at any time during the year.
Married filing joint or qualifying widow(er) = $228,000 or more
Married filing separate (lived with spouse at any time during the year) = $10,000 or more
Reduced contribution limits are available for taxpayers with incomes that are within $10,000–$15,000 of these limits, depending on the filing status.
What do I do if I make too much money?
Once you make too much money to contribute to a Roth IRA, pat yourself on the back for reaching this milestone. This is a good problem to have. Fortunately, you can still contribute to a Roth IRA with a perfectly legal two-step process. Congress could theoretically close this loophole at any point, but since they have seemed pretty uninterested in doing so ever since Roth IRAs made their debut—my guess is that many of them take advantage!—I would not lose any sleep over the possibility.
Step 1: Contribute to a traditional IRA.
The first step is to contribute to a nondeductible traditional IRA. Yes, you read that right. If you do not have a traditional IRA, you can open one in just a few steps. Your best bet is to use the same brokerage that houses your Roth IRA because that will make the second step easier. If you do not have any IRAs, then I suggest using a low-cost option like Vanguard or Fidelity. (Xa and I both have our IRAs at Vanguard, and we find that Vanguard makes converting a traditional IRA to a Roth IRA very easy.)
The “nondeductible” part just means you do not take a tax deduction for your contribution, even if you are eligible to do so. When you contribute to a traditional IRA, your brokerage does not know (or care!) whether you are deducting those contributions; that part is up to you.
A common question I get is “why contribute to a traditional IRA if I am not going to take a deduction for it?” The answer is simple: It will not be staying there.
Step 2: Convert your traditional IRA to a Roth IRA.
The second step is to convert your traditional IRA to a Roth IRA. Make sure you do this as a direct trustee-to-trustee transfer, without you ever actually touching the money. The specifics of how to do this will vary depending on your brokerage. Vanguard, for instance, makes this easy by literally having a “Convert to Roth IRA” button on the screen showing your traditional IRA holdings:
A conversion is just like a rollover, except that you are moving it not just from one account to another, but from one type of account to another.
And there you have it! You have sidestepped the Roth IRA contribution limits. This two-step process is known as a backdoor Roth.
(You may have also heard of a “mega backdoor Roth” and/or a “Roth IRA conversion ladder.” Those are separate topics for another day.)
Why does this work?
Some folks are wary of the backdoor Roth because it seems almost too simple. It would make more sense if Congress just removed the income limits for Roth IRAs, but good luck with that!
The backdoor Roth works for two reasons. First, you can convert any portion of your traditional IRA to a Roth IRA at any time, just like you can roll over an IRA to another (or a 401(k) to an IRA). When you convert pre-tax money to a post-tax account, you pay tax on the amount converted, but the 10% early-withdrawal penalty does not apply because that money is still in an IRA.
Second, because you are not deducting the traditional IRA contribution you made in step one, that contribution is effectively post-tax money, so you do not pay taxes when you convert that money to a Roth IRA in step two.
Strictly speaking, if the value of your traditional IRA increases, you will pay tax on the growth when you convert (but no penalty, since you are not withdrawing the money). For example, if you contribute $6,500 to a traditional IRA that grows to $6,700 by the time you convert, you will pay tax on the $200 growth; if that $6,500 declines to $6,350, there is no growth so you will pay no tax.
Are there time limits?
The best time for step two is immediately after step one, so that there is minimal or no growth on which to pay taxes.
Of course, if you contribute monthly to your IRA, this would mean converting twelve times throughout the year. That is a lot, even with Vanguard’s literal click-of-a-button process for converting. For some folks, the small amount of taxes on the growth that happens when they convert once a year is worth it to avoid the hassle. You can also hit the middle ground by converting a few times throughout the year.
What pitfalls do I need to avoid?
The backdoor Roth works best if you zero out all your traditional IRAs by the end of each calendar year. (This includes SEP and SIMPLE IRAs, if you have them.) I cannot stress this point enough.
When you file your tax return, you will report Roth IRA conversions on Form 8606. (Standard tax software will include this form.) If you leave a balance in your traditional IRA(s), a portion of your conversion will be taxable based on the ratio of your deductible (pre-tax) contributions to nondeductible (post-tax) contributions.
For example, if you have $40,000 in pre-tax contributions and $10,000 in post-tax contributions sitting in one or more traditional IRAs, you will pay tax on 80% (i.e., $40,000 pre-tax contributions ÷ $50,000 total contributions) of the amount converted. Avoid this problem by emptying your traditional IRA(s)!
Even if you can identify the specific shares converted (like you can with tax-loss harvesting for regular capital gains), perhaps by using an entirely separate traditional IRA for your backdoor Roth, the pro-rata taxation rule still applies.
Be aware that any taxes owed as a result of Roth IRA conversions do not get withheld from the amount converted. You need to be prepared to pay these taxes when you file your tax return for the year.
Another quirky pitfall to avoid is inadvertently canceling any automatic investments. If you convert 100% of your traditional IRA balance, any automatic investments into that traditional IRA may be canceled as well, and you might not be able to set them up again without meeting your desired fund’s minimum investment requirements. (Ask me how I know!) The solution is to convert all but 0.001 shares. Because you still have an existing balance, any automatic investments you have scheduled will remain in place. And because you only have 0.001 shares, the balance will round down to zero when completing your taxes (assuming the December 31 value is below $500 per share)! If you can do a partial conversion by dollar amount instead of number of shares, just leave $0.10 in there.
What if I already have a large traditional IRA balance?
If you have any pre-tax money in a traditional IRA, you will pay taxes at step two. If the balance is small, the path of least resistance is to simply pay the tax. If you have a large balance, though, you still have options to avoid a large tax bill.
Line 6 of Form 8606 asks for the year-end balance of all your traditional, SEP, and SIMPLE IRAs. It does not ask for your year-end 401(k) balance! If you have a traditional IRA balance on which you do not want to pay taxes, simply roll this money into an existing 401(k)!
The overwhelming majority of 401(k) plans will accept direct rollovers from other 401(k) plans. Many folks are already familiar with this process because it makes sense to consolidate when you move from job to job. Most 401(k) plans will likewise accept direct rollovers from traditional IRAs as well. Contact your plan administrator for details and directions.
If you are self-employed, you can open your own 401(k)! Then, roll your traditional IRA into it.
In my case, I emptied my traditional IRA (which was a collection of money rolled over from previous workplace retirement plans) into the federal Thrift Savings Plan—the federal government equivalent to a 401(k) plan—and then followed the two-step backdoor Roth process.
What if I have already made Roth contributions this year, and just now realized that I will make too much money?
The backdoor Roth is easier if you know at the beginning of the year that you will make too much to contribute to a Roth IRA directly, but many folks will not realize they have crossed the income threshold until after they have already contributed to a Roth IRA (perhaps because of a raise, bonus, or unexpected income).
If you find yourself in this situation, simply recharacterize the Roth IRA contributions you have already made. Then, moving forward, make nondeductible traditional IRA contributions as described above.
A recharacterization effectively allows you to go back in time and treat your Roth IRA contributions as if they had been made to a traditional IRA. Your IRA custodian moves the Roth IRA contributions over to a traditional IRA. Contact your custodian for specific instructions.
You have until the due date of your tax return to effect a recharacterization.
A recharacterization is irrevocable.
Once you have recharacterized any Roth IRA contributions already made, they are treated as if they had been traditional IRA contributions. Proceed to step two!
What if I have additional questions?
There may be other nuances or complications to your particular situation beyond what is covered here, or perhaps you simply feel more comfortable having someone walk this path with you. We offer fee-only financial planning at Phippen Tax and Financial Services. As a fiduciary, I put your interests first and do not earn any commissions based on my recommendations. Reach out to us for help today!
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