Get Around Roth IRA Income Limits

February 3, 2015

saving-for-retirementWhen it comes to saving for your retirement, one of the best tools at your disposal is the Roth IRA, which allows you to generate tax-free income in retirement. But Roth IRAs come with a catch—you can't contribute directly to these accounts if your income exceeds certain amounts. Fortunately, there's a workaround that may allow you to set money aside in a Roth, even if you earn too much to contribute directly. It's called a "backdoor Roth contribution."

Roth IRA Rules

First, let's review a few basic Roth IRA rules. A Roth IRA works much like a traditional IRA. You set up the accounts, save money and make withdrawals when you need them in retirement. But there's one big difference: Unlike a traditional IRA, you don't deduct your contributions from your income taxes in the year you make them. However, when you take withdrawals, you pay no taxes on either the initial contributions or the earnings in the account. It's a great deal for those who expect their tax bracket in retirement will be higher than it is today.

In 2015, you can contribute up to $5,500 to your Roth IRA, traditional IRA or combination of the two. (Those over age 50 can make an additional $1,000 catch-up contribution each year.) But not everyone is eligible to contribute. If you are married filing jointly, you gradually lose the ability to contribute to a Roth IRA when your modified adjusted gross income (MAGI) is between $183,000 and $193,000. If you are single, the phaseout range is between $116,000 and $131,000 of MAGI.

Earn Too Much to Contribute? A Roth IRA Workaround

If you're a high-income earner, you may assume that you are shut out from contributing to a Roth IRA. While it's technically true that you can't make Roth contributions if your income exceeds certain levels, there is a potential way around this rule, though it won't be appropriate for all people. It involves converting a traditional IRA to a Roth IRA and is commonly known as a "backdoor Roth."

Since 2010, the IRS has allowed people of all income levels to convert assets in a traditional IRA to a Roth IRA, provided they pay tax on any previously untaxed assets. Of course, people who earn too much to contribute to a Roth IRA also earn too much to make deductible contributions to a traditional IRA, which have lower income phaseout levels than Roths. However, anyone can make a nondeductible contribution to a traditional IRA, regardless of their income.

Backdoor Roth contributions take advantage of this rule. High-income people simply make nondeductible contributions to a traditional IRA and then immediately roll those assets over to a Roth IRA. Because you make the conversion quickly, the money in the account has little or no time to grow, so you should owe either no tax or very minimal tax.

Sound like a great deal? It is. But it doesn't work for everyone. If you have existing traditional IRAs, things get complicated, because the IRS will look at money in all your IRAs to determine taxes due. If you have to fork over a lot of cash to the IRS to pay taxes on the conversion, the backdoor Roth strategy can be less appealing.

Because backdoor Roth contributions can be complicated, we suggest consulting with a financial professional before pursuing this strategy. If you think you might want to make a backdoor Roth contribution or explore other Roth IRA strategies as part of your retirement planning, we'd be happy to talk to you about your options.