The 2015 limit for Roth IRA contributions is $5,500 ($6,500 for those 50 or older). If your income is above $131,000 ($193,000 for those who are married and filing jointly), you can’t contribute anything to a Roth.
Or so the published IRS limits would have you believe.
In fact, there are two strategies that can be used to get around these limitations. Both involve first contributing after-tax dollars to a different savings vehicle, and then converting or rolling them over to a Roth. There are complications and potential downsides to each strategy, so it is important to review your options with an advisor before pursuing them.
Strategy #1: The Backdoor Roth
If your income is too high to contribute to a Roth, then it’s also too high to make deductible (pre-tax) contributions to a traditional IRA (assuming your or your spouse is covered by a workplace retirement plan). But you can always make nondeductible (after-tax) contributions to a traditional IRA. And then you can convert them to a Roth.
There’s a catch, which is that the IRS treats a Roth conversion as coming proportionately from all of the dollars in all of your traditional IRAs—even if your after-tax contributions are segregated in their own account. For example, if you have a pre-existing traditional IRA with $94,500 pre-tax, and fund a new IRA with $5,500 after-tax, then your $5,500 conversion is going to be 94.5% taxable. Anyone looking to do a backdoor Roth is, by definition, in a high tax bracket, so this outcome is not desirable.
Of course, this isn’t a problem if you don’t have an IRA with pre-tax dollars. Just open an IRA, make after-tax contributions, and convert them without generating any tax liability. (Repeat each year, as necessary.) But if you do have an IRA with pre-tax dollars, it’s still possible to get around the tax issue. Just roll all of the pre-tax dollars into a 401(k) or 403(b) before converting your after-tax IRA dollars into a Roth.
Strategy #2: After-Tax Retirement Plan Contributions
This second strategy is potentially even more powerful, but not everyone can take advantage of it. If you have a 401(k) or 403(b) that accepts after-tax contributions in addition to the $18,000 ($24,000 for those 50 or older) employee contribution limit, a recent IRS regulation now allows you to easily roll the after-tax dollars into a Roth when you separate from your employer.
So, let’s say you contribute $18,000 to your 401(k), and your employer contributes another $5,000. In theory, that leaves room for you to contribute an additional $30,000 in after-tax dollars before you reach the total limit for 401(k)s of $53,000. (In practice, a plan’s nondiscrimination testing usually places a lower limit on after-tax contributions.) You’ll need to wait until you change employers or retire before you can actually roll the after-tax dollars into your Roth; but, under current law, you’ll eventually be able to do so without tax consequences.
Once money is in a Roth, you can let it grow there for the rest of your life, and neither you nor your heirs will ever have to pay tax on withdrawals (provided certain requirements are met). The two strategies described above can help you save more to a Roth than you might have thought possible.
One caveat is that these strategies seem counter to the spirit of published IRS limits, and they disproportionately benefit wealthier individuals who have access to good financial advice. As we’ve seen with the recent changes to Social Security, these sorts of “loopholes” tend to get closed.
That said, even if conversions and transfers to Roth are eventually disallowed, making after-tax contributions to an IRA or 401(k) would still give you the benefit of tax-deferred growth. The possibility that you might be able to move these contributions to a Roth just makes them all the more attractive.
By Jeffrey P. Ebert, PhD, CFP® / Financial Advisor
Jeff holds the CFP® designation and earned his doctorate in social psychology at Harvard University. Jeff has expertise in retirement and education planning.
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