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Roth Savings Strategies for High Earners: Strategy #1 – the Back Door Roth IRA

Roth IRAs and 401(k)s are wonderful savings vehicles. Although you cannot claim a tax deduction for them, their earnings are untaxed and there is no income tax due when withdrawn in retirement, providing some requirements are met.

Whenever possible, we recommend some portion of savings be devoted to Roth accounts. Ideally, entering retirement, one would have a mix of tax deferred savings (traditional IRAs and employer savings), taxable money, and Roth money. This provides multiple ways to draw down your accounts in retirement and provides much more flexibility in tax planning.

However, if you are a high earner while employed, it can be difficult to contribute to Roth accounts because:

  • There are limits on income for direct contributions to Roth IRAs. In 2016, Roth IRA contributions phase out starting at $184,000 for married filing jointly taxpayers, and they are completely eliminated at $194,000.
  • High earners frequently need to take full advantage of salary reduction plans at work to lower their taxes; thus, even if their employers offer Roth options, they may not feel they can take advantage.

The Back Door Roth IRA

Starting in 2010, Congress changed the rules for converting from a traditional to a Roth IRA. Beginning with that tax year, there is no longer an income limit on converting a non-deductible traditional IRA to a Roth IRA.

So how do you do this? There is one potential pitfall to be aware of, but with some planning, you can take advantage of this strategy for additional tax savings.

Important Condition Prior to Making the Contribution

Before using this approach, make sure that you do not have any SEP-IRA, SIMPLE IRA, traditional IRA, or rollover IRA money.  The total sum of these accounts on December 31st of the year in which you do Step 3 must be zero to avoid a “pro rata” calculation that can eliminate most of the benefit of a Backdoor Roth IRA.

The pro-rata rule is often referred to as the cream-in-the-coffee rule. Once the cream and coffee are combined you cannot separate them; in the same way, blending before-tax and after-tax funds in any Traditional IRA(s) cannot be separated. This is true even if you keep the before-tax amounts in a different Traditional, IRA from the after-tax amounts, as the values of all Traditional IRA(s) are combined for purposes of determining the percentage of any distribution or conversion that is taxed.

So how to deal with existing traditional IRA money?

  • Convert the entire sum to a Roth IRA. This approach is really only practical if it does not bump you into a higher tax bracket and you can afford to pay the taxes out of current earnings or taxable investments with relatively high cost basis.
  • Roll the money over into a 401K, 403B, or Individual 401K.  401Ks don’t count in the aforementioned pro-rata calculation.  Some people have even opened an Individual 401K that accepts IRA rollovers in order to facilitate a Backdoor Roth IRA.

Contribute to a non-deductible IRA

Next, make a $5,500 ($6,500 if over 50) non-deductible traditional IRA contribution for yourself, and one for your spouse.  You can use the same traditional IRA accounts every year, leaving the account open after you make the conversion.  (Most fund companies don’t close the account just because there is nothing in it most of the year).  I do this every January and place the contribution in a money market fund. Since it yields next to nothing, you will not have much in the way of gains that could be taxed at conversion; you will also not have any losses.

Convert the non-deductible IRA to a Roth

Convert the non-deductible traditional IRA to a Roth IRA by transferring the money from your traditional IRA into your Roth IRA at the same fund company.  If you don’t already have a Roth IRA account, you’ll need to open one.  This can easily be done online at most fund companies.  The transfer is considered a taxable event, but the tax bill should be zero if you initially put the money in cash as described earlier.  Once the money is transferred to the Roth, you can invest the money according to your investment plan.

The Step Transaction Doctrine

Some people are concerned that the IRS will have a problem with the Backdoor Roth due to an IRS rule called The Step Transaction Doctrine.  This rule says that if the sum of several legal steps is illegal, then you can’t do it.  Since a high earner can’t legally make a direct Roth IRA contribution, then some have wondered if the IRS will really allow them to use the back door Roth strategy.

Some experts recommend waiting a short period of time (anywhere from a day to six months) before doing the conversion so you can prove that wasn’t really your intent.  Another method to avoid the Step Transaction Doctrine is to convert last year’s non-deductible contribution this year, then make a new non-deductible contribution for this year to “introduce economic uncertainty” as to whether you’re going to convert or not.

Fortunately, many fund companies will not let you do your Roth conversion immediately; mine will not allow a conversion for about two to three months (I have not tracked the actual time, but have just gone back periodically to see if I can do the conversion yet). This helps safeguard against tripping the Step Transaction Doctrine.

When you do your Taxes

When you do your taxes for the year of the conversion, remember to fill out Form 8606 for each person funding a non-deductible IRA.

Congratulations, you are now accumulating Roth money! There are a few steps and things to be aware of, but it is not too difficult and provides you a tax-free source of money in retirement. Make it a habit to fund one every January for both yourself and your spouse if married, and head for financial independence!