Over four years ago, the sketch comedy duo, Tripp and Tyler, blessed the internet with a one minute video cataloging all the things that nobody ever says. There were lines I would have never thought of like “I just got the best deal on printer ink” and “Hey, can I burn a copy of your Nickelback CD?,” but they also threw in obvious choices like “I’ve got too much money,” which is something that not even Oprah would be guilty of saying. However, when dealing with the IRS that may very well be the case: If you make too much money, you cannot contribute to a Roth IRA.
Anyone with a cursory knowledge of personal finance knows that Roth IRAs are a fantastic way to save for retirement. They were created through the Taxpayer Relief Act of 1997 and named after Senator William Roth of Delaware, their primary sponsor. Roth IRAs allow you to make non-deductible contributions up to $5,500 per year that can grow tax-free and are available for tax-free distribution after you reach the age of 59 ½.
So why would you ever need a “backdoor” Roth IRA? Well, if you make too much money, then unfortunately you are ineligible to contribute directly to a Roth IRA. More specifically, in 2016 if you are married and make over $194,000, you cannot contribute to a Roth IRA. BUT you can still contribute to a non-deductible traditional IRA and convert it to a Roth IRA, and that is what we refer to as a backdoor Roth contribution.
Let me walk through that process. A non-deductible traditional IRA is seemingly the worst of both a Roth and traditional IRA—you cannot deduct contributions and you are taxed on distributions. However, after you contribute to a non-deductible traditional IRA, you can then make an election to convert the account to Roth. And since you did not take a tax deduction for the original contribution, your basis in the account would be the same as your contribution, so the conversion would not trigger any taxable income.
Keep in mind that this process is more complicated if you also have a traditional IRA because you cannot specify which accounts you are converting. IRS rules mandate that you treat conversion amounts pro-rata with all IRA account balances. For example, if you make a $5,500 non-deductible traditional IRA contribution to a new account, but you already have a traditional IRA worth $49,500, the conversion will trigger $4,950 in taxable income. Your aggregate IRA balance would be $55,000 ($5,500 + $49,500), and since 90% ($49,500 / $55,000) of that balance has been untaxed, 90% of the conversion ($4,950) must be taxed. So you can make the conversion, but it will not be tax free as in the case without an existing traditional IRA balance.
The point is that you may make too much money for a direct Roth IRA contribution, but you may also be eligible for this alternative funding method. It requires a little more work administratively, but your IRA custodian should be able to help you through the process.
Josh Norris is an Investment Advisory Representative of LeFleur Financial. Josh can be reached at josh@LeFleurFinancial.com.