High earners who exceed annual income limits set by the IRS can’t make direct contributions to a Roth IRA.
The good news is that there’s a loophole to get around the limit and reap the tax benefits that Roth IRAs offer. This strategy, known as a backdoor Roth IRA, allows those with high incomes to make indirect contributions.
Key Takeaways
- High earners may not be able to make direct contributions to a Roth IRA due to income limits set by the IRS.
- A loophole, known as the backdoor Roth IRA, provides a way to get around the limits.
- In a backdoor Roth IRA, a person makes a nondeductible contribution to a traditional IRA, and then converts that account to a Roth IRA.
- Tax implications will come into play in determining whether this strategy is worthwhile for you.
Roth IRA Income Limits
Roth IRAs provide unique tax advantages for retirement savers. The money contributed to the account is taxed in that year. But when the account owner withdraws the money, presumably after retirement, no further taxes are due on either the money contributed or the growth achieved.
But those with modified adjusted gross incomes (MAGI) above certain levels are limited in the amounts that they can contribute, or banned from Roth ownership altogether. The income limits are updated annually.
For the tax year 2021, the limits are as follows: Single and head-of-household filers with MAGIs of $125,000 to $140,000 can contribute limited amounts, as can married taxpayers filing jointly with incomes from $198,000 to $208,000.
How Can I Fund A Roth IRA If My Income Is Too High To Make Direct Contributions?
For the tax year 2022, single and head-of-household filers with MAGIs of $129,000 to $144,000 can contribute limited amounts. For married couples filing jointly, the income phase-out range is $204,000 to $214,000.
Taxpayers with incomes above those top numbers cannot contribute at all to a Roth. However, all is not lost for those who exceed the limit.
The Build Back Better infrastructure bill—passed by the House of Representatives and currently being considered by the Senate—includes provisions that would eliminate or reduce the use of Roth conversions for wealthy taxpayers in two ways, starting Jan. 2022: (1) Employees with 401(k) plans that allow after-tax contributions up to $58,000 would no longer be able to convert those to tax-free Roth accounts. (2) Backdoor Roth contributions from traditional IRAs, as described below, would also be banned. Further limitations would go into effect in 2029 and 2032, including preventing contributions to IRAs for high income taxpayers with aggregate retirement account balances over $10 million and banning Roth conversions for high income taxpayers.
The Backdoor Roth IRA Strategy
The removal of a $100,000 MAGI limit for Roth conversions in 2010 created a loophole in the tax code that allows high-income filers to legally make indirect contributions to Roth accounts using the backdoor Roth IRA strategy.
A backdoor Roth IRA is not a type of retirement account, but rather a strategy to convert funds in a traditional IRA or 401(k) to a Roth IRA.
To use the backdoor Roth IRA strategy, you’ll need to take the following steps:
- Open a traditional IRA with your IRA custodian of choice. It is usually easiest, but not necessary, to use the same custodian that holds your Roth conversion IRA or where you plan to open your Roth.
- Make a fully nondeductible contribution to your traditional IRA. The contribution limit for 2021 and 2022 is $6,000, plus an additional $1,000 catch-up contribution for those aged 50 and above. That means not reporting your traditional IRA contribution as a deduction for MAGI on your 1040, even if you might otherwise be eligible to deduct it.
- Next, convert the traditional IRA balance into a Roth IRA. Because the MAGI threshold for contributions does not apply to conversions, the income limitation does not apply.
- Repeat this process every year that your MAGI is too high to allow you to make a direct contribution to your Roth IRA.
Tax Scenarios and Other Considerations
The backdoor strategy works best if you don’t already have a traditional IRA because it will leave you owing no taxes on your contribution. If you do have a traditional IRA that you have funded with deductible contributions, however, the tax benefit will be reduced, and computing your taxes becomes more complicated.
Understanding this takes time, but it’s worth paying attention to the following three situations or discussing them with your tax advisor.
Example 1: You Owe Zero Taxes
You are 40 years old and make $200,000 a year. You open a new IRA and make a nondeductible $6,000 contribution. You then convert this account with the $6,000 to a Roth IRA. You have no other traditional IRAs. Your tax bill for the conversion is zero because you did not deduct your contribution.
Example 2: You Owe Taxes on All Previous IRA Balances
Your actions and circumstances are identical to the first situation, except that you also have a traditional IRA rollover account that was funded entirely with deductible contributions. You got a tax deduction when you made these contributions.
If you try to convert the entire amount you have in IRAs—both your $6,000 non-deductible contribution and the rest of your IRA balance—you will have a tax bill. How much you owe depends on how large that rollover IRA is, and your current income.
This is because under the pro-rata rule, all your IRAs are treated as one communal IRA. The amount of your Roth IRA conversion that is taxable is proportional over your total IRA balance.
Figuring the Tax Bill
If the IRA is worth $49,500, $5,352 of your $6,000 would be taxable:
- Nondeductible contribution to traditional IRA = $6,000
- IRA rollover balance = $49,500
- Total of contribution plus IRA balance = $55,500 ($6,000 + $49,500)
- $6,000/$55,500 = 0.108 = 10.8%. This is the percentage of your conversion that will be non-taxable.
- $6,000 x 10.8% = $648 nontaxable conversion balance
- $6,000 – $648 = $5,352 taxable conversion balance
- Only the $648 will be subtracted from the total contribution as nontaxable
If the IRA is worth $3,000, only $1,980 would be taxable:
- Nondeductible contribution to traditional IRA = $6,000
- IRA rollover balance = $3,000
- Total of contribution plus IRA balance = $9,000 ($6,000 + $3,000)
- $6,000/$9,000 = 0.666 = 67%
- $6,000 x 67% = $4,020 nontaxable conversion balance
- $6,000 – $4,020 = $1,980 taxable conversion balance
- $4,020 will be subtracted from the total contribution as nontaxable
If you have one or more IRAs that you funded with deductible contributions, even the backdoor strategy cannot keep you from owing taxes on a Roth conversion. You can’t open a second IRA and roll over only that second account and owe no taxes.
Your Roth IRA, by the way, will just have the $6,000 in it. Your other IRAs won’t be folded into it; they’ll just be included in the government’s tax calculations. The tax bill will be assessed regardless of whether a new or existing account is used.
Example 3: You Owe Taxes on Some IRA Balances
This is a more complex circumstance, but the math is fairly straightforward. Under the pro-rata rule, IRA conversions are taxed in proportion to the amount of taxable contributions across all of your IRA balances.
Imagine you are the same age with the same income as in the previous examples. You could have several IRAs that were funded partly with deductible contributions and partly with nondeductible contributions. For the sake of simplicity, though, imagine you have just two traditional IRAs, one funded each way:
- IRA 1 ($60,000): Funded only with deductible contributions
- IRA 2 ($34,000): Funded only with nondeductible contributions
You open a third traditional IRA with a $6,000 non-deductible contribution and convert that balance to a Roth IRA. The taxable proportion of your contribution is equal to the percentage of taxable contributions across all of your IRAs. Since 60% of your IRA balances were funded with pretax (deductible) contributions, and 40% with non-deductible (after-tax) contributions, 60% of your conversion will be taxable.
For a $6,000 conversion, that means that $3,600 will be classified as income for the year of conversion. Depending on your annual income, that may move you to a higher tax bracket.
While a backdoor Roth IRA is still a viable strategy as of 2021, House Democrats have recently proposed legislation that would restrict conversions from higher-income individuals starting in 2022. As of November 2021, no legislation has yet been passed.
The Backdoor Strategy and Qualified Retirement Plans
If you or your spouse participates in a traditional qualified retirement plan at work that accepts rollovers of pre-tax (deductible) IRA balances, then you have another avenue with which you can avoid tax when you use the backdoor strategy to fund a Roth. Here’s how:
Roll over all your deductible IRAs into a traditional 401(k) at work before starting the conversion process. Then, open a new IRA with a $6,000 non-deductible contribution and convert that amount into a Roth IRA. Your tax bill will be zero because the government doesn’t include qualified-plan balances in calculating the tax on a backdoor Roth conversion. However, not all 401(k) plans offer this benefit.
Contribute to a Roth 401(k) If You Can
The backdoor strategy is unnecessary if your employer offers a Roth 401(k), and you are not making the maximum possible contribution. Roth 401(k) plans let you contribute up to $19,500 in 2021 and $20,500 in 2022 in after-tax dollars that you can collect tax-free when you retire.
If you have only contributed $5,000 to your Roth account in the plan, then it would be simplest to contribute the remaining $14,500 in 2020 before opening a backdoor IRA. If you are 50 and older, you can contribute an additional $6,000 to a Roth 401(k).
One possible exception to this rule could be if you are unhappy with the investment choices that are offered inside the plan and wish to explore alternative options elsewhere.
The Bottom Line
High earners can circumvent contribution limits to Roth IRAs by using the backdoor strategy. You save the most if you do not have preexisting traditional IRA balances that must be factored into your tax bill or if your employer’s qualified plan allows rollovers of deductible IRA balances.
Advisor Insight
Josh Brein
Brein Wealth Management, LLC, Bellevue, Wash.
One way to contribute to a Roth IRA is to utilize a backdoor Roth IRA conversion (if you make more income than the limits allow).
Sound complicated? A little bit, but in theory, this process is actually pretty simple. Although there are income limitations to funding a Roth IRA, there are no income limitations to converting to a Roth IRA. So if you were to contribute to a traditional IRA, which does not have contribution rules that are determined by your income, in theory, you could convert to a Roth IRA and all you have to do is pay taxes on the full amount of the conversion which could be up to $7,000 (depending on your age).
Once you have converted your IRA to a Roth IRA you will have to pay taxes on the conversion, but moving forward, your growth and your distributions from the Roth IRA will be tax-free.
The Roth IRA conversion is a commonly used strategy for those that earn an income which is above the asset limits for contributing to a Roth IRA.
