Many higher-income earners are not eligible to contribute directly to a Roth IRA under the current income limits. For 2020, married couples with modified adjusted gross income (MAGI) in excess of $206,000 (or $139,000 for individuals) are not allowed to contribute directly to a Roth IRA, but they may be able to contribute indirectly via a backdoor Roth IRA contribution.
Step 1. Make a Non-Deductible Contribution to a Traditional IRA:
Regardless of how high your income is, anyone with earned income can make a non-deductible contribution to a traditional IRA. For 2020, the maximum annual contribution limit to an IRA is $6,000, plus an additional $1,000 in catch-up contributions for those who are 50 or older.
Step 2. Convert Your Contribution to a Roth IRA:
Regardless of income level, anyone can do Roth conversions. The non-deductible contribution being converted is after-tax money, so this portion of the conversion would not trigger any additional taxes. If the individual has any pre-tax money in any other IRAs, part of the Roth conversion amount could be taxable due to the pro-rata rule (more details listed below).
Pro-Rata Rule: The pro-rata rule states that when an individual has multiple IRAs, including all traditional IRAs, SEP-IRAs, and SIMPLE IRAs, they will all be treated as one account when determining the tax consequences of any distributions (including Roth conversions). If an individual has any pre-tax money in any other traditional IRAs, SEP-IRAs, or SIMPLE IRAs, that could cause part of the Roth conversion amount to be taxable. It’s important to note that the IRS applies the pro-rata rule to your total IRA balance at the end of the year, not at the time of conversion.
Timing Between Contribution and Conversion: Due to the pro-rata rule, any earnings on the non-deductible contribution while in the traditional IRA, which grow tax-deferred, could cause a portion of the Roth conversion amount to be taxable. Doing the conversion immediately after you make the non-deductible contribution helps to avoid paying any additional taxes on potential earnings while in the traditional IRA.
John (60 years old) would like to contribute the maximum annual amount to his Roth IRA but is not eligible because his MAGI is $200,000 in 2020 and exceeds the income limit for Roth contributions. He can do a backdoor Roth IRA contribution by making a non-deductible contribution of $7,000 to his traditional IRA and then immediately converting that money to his Roth IRA. Assuming that he doesn’t have any pre-tax money in any other IRAs, this conversion would not trigger any additional taxes. If John had another traditional IRA with $21,000 of pre-tax money in it, then 75% of his conversion amount (or $5,250) would be taxed as ordinary income.
To understand how backdoor Roth contributions may work for you, contact Dowling & Yahnke Wealth Advisors (858-509-9500) to speak with one of our advisors or contact us here.