If you make too much to be eligible to contribute to a Roth IRA, Money Girl explains how to create a backdoor Roth - and whether doing so is a smart move for your situation, and your financial needs.
Everyone likes to make more money, but sometimes being a high earner disqualifies you from certain tax benefits—like making contributions to a Roth IRA. It’s the only type of retirement account that locks the doors when your income exceeds certain annual limits.
However, the good news is that even if you make too much to be eligible to contribute to a Roth IRA, there’s actually a strategy you can use to create one. It's known as a backdoor Roth IRA, and in this episode, I’ll explain what it is, and whether creating one is a smart move for your situation.
What Is the Benefit of a Roth IRA?
A Roth IRA or Individual Retirement Arrangement is a type of account that allows to you to save for retirement while getting some terrific tax benefits. You make contributions to a Roth on an after-tax basis, and then never pay tax on contributions or earnings in the account again. So when you take withdrawals to spend in retirement, they’re completely tax-free.
Additionally, unlike a traditional IRA, with a Roth you can make contributions at any age, and are never required to take minimum distributions. That means if you don’t need to spend the money, it can continue to grow and be passed along to your heirs, if you like.
These tax benefits are about as good as they get. However, as I previously mentioned, if you’re fortunate enough to be a high earner, you can’t make Roth IRA contributions.
The income cutoff for 2015 if you’re married and file taxes jointly is $193,000. If you’re single, the income limit is $131,000.
So how does a backdoor Roth IRA fit into this picture? Well, first you need to understand the concept of doing a Roth conversion.
What Is a Roth Conversion?
Since the tax benefits of a Roth IRA are so attractive, you’re allowed to convert a traditional IRA into a Roth IRA, no matter your income. However, when doing this you take an immediate tax hit.
Remember that funds go into a Roth on an after-tax basis. So doing a Roth conversion means you have to settle up your tax bill with the government. And paying all that tax at once is a bummer.
For instance, if you convert $100,000 from a traditional IRA to a Roth and have a tax rate of 25%, you’ll owe $25,000. Even worse, if you dip into the account before reaching age 59½ to pay the tax, you’ll also be charged a 10% early withdrawal penalty. Now you’ll owe 35% or $35,000—not a good idea.
Since converting a traditional IRA to a Roth requires such a big tax hit, I don’t recommend it. However, there’s another kind of traditional IRA that’s nondeductible or taxable. This is how you can sneak into a Roth IRA, even if you earn too much.
Free Resource: Retirement Account Comparison Chart (PDF download)