Can’t qualify for a Roth IRA? There’s a back door.
When you choose to invest in a Roth IRA, you can contribute $5,500 in 2018 and an additional $1,000 if you are age 50 or older. You can’t deduct these contributions on your taxes, but upon withdrawal your earnings are tax-free. Sounds great, right? Well, there’s a catch. If your modified adjusted gross income (AGI) is more than $196,000 for married joint filers or $133,000 for single filers, you cannot make a Roth contribution.
Can you still take advantage of a Roth if you exceed the income limits? Yes, but you’ll have to use the back door, and there are several strategies you can use.
First, look at your employer’s retirement plan. Do they allow you to make Roth contributions? Under the 401(k) rules, you can contribute up to the IRS maximum of $18,500 (for 2018). This is much higher than the IRA limit.
If that’s not an option for you, you can make a non-deductible contribution to a Traditional IRA and convert it to a Roth. There are no income limits on a conversion, and it can be made tax free. There’s always a “but” when you want to use an alternative option, so if you hold any other IRAs with deductible contributions, you need to determine the taxability of the converted amount on a pro-rata basis.
How does the pro-rata rule work? Let’s say you open a new IRA with a non-deductible contribution of $5,000, and you have a second IRA that is fully taxable upon distribution of $20,000. Your total IRA balance is $25,000 and that $5,000 is 20 percent of all IRAs. Only 20 percent of the $5,000 conversion will be tax-free. You will need to pay tax on the remaining $4,000.
What’s your next move? Look at your 401(k) plan. Does your employer allow you to roll over IRA funds into your plan? If so, the plan will only accept pretax funds. Roll over that $20,000 into the retirement plan so all you have left is the after-tax IRA waiting for the Roth conversion. If you want to take advantage of this approach, we suggest you complete the rollover in one tax year and the Roth conversion the following tax year.
Another option would be to use a spousal IRA for a nonworking spouse. Since IRAs are individually owned, a spouse’s IRA would not be combined with your IRAs for the pro-rata rule.
Finally, if you are a sole proprietor, open a retirement plan with a non-deductible contribution option. Maximize your contributions and then convert it to a Roth.
Regardless of how you approach the back door, it is important that each action is an independent transaction.
If you’d like more information to learn more about your IRA options, call us at 937.615.1056.