It’s the end of another year, and people are celebrating Christmas, attending holiday gatherings, making their charitable contributions for 2014, and looking forward to 2015. One end of the year item on some peoples’ list is to make contributions to their Roth IRAs.
Roth IRAs are a great tool for building retirement assets, especially if you start contributing to them when you are young. Contributions to a Roth are not tax deductible, unlike traditional IRAs. The benefit of a Roth is that your money grows tax-free. Generally once you reach age 59 1/2, the money that you withdraw from the Roth is tax-free too. A significant advantage of a Roth for many people is that you are not required to take required minimum distributions (RMD) at age 70 1/2. Traditional IRAs and other retirement plans such as 401ks require the account owner to take distributions, and be taxed on those distributions. In our firm we find many frugal, diligent savers are facing significant tax bills in their later years because of the RMDs that they will have to take. A Roth IRA alleviates this issue.
As with most things there are a few complicating factors to Roth contributions. First, you can only contribute earned income (i.e. from a job or self-employment). Second, if, as a single tax filer, your modified adjusted gross income (MAGI) is greater than $114,000 you cannot directly contribute to a Roth. The same is true for couples filing jointly with a MAGI of $191,000. These figures are for 2014 contributions.
Is there a way for high-income earners to contribute to a Roth? Fortunately, there is. The strategy is commonly referred to as a “backdoor” Roth. A recent article by Vanguard describes the process.
The article does an excellent job of explaining the process and the advantage of backdoor Roths; with one exception. The article states, “From a tax standpoint, this strategy works best if you don’t have other traditional IRA assets.” The article does not elaborate on this point but it is a significant issue. Note that it says other IRA assets, this does not include money in a 401k, 403b, or other non-IRA retirement plans.
If you do have another IRA and you make a backdoor Roth conversion, you are subject to the pro-rata rule. Here is an example. Joe is 55 and has an income that exceeds the maximum, but would like to start a Roth IRA. He currently has a traditional IRA of $100,000. Joe wants to make a $6,500 after tax contribution to a traditional IRA and immediately convert it to a Roth IRA, a backdoor Roth contribution. Since Joe has an existing IRA, he is subject to the pro-rata rule which imposes a second tax on $6,103.29 of his after-tax contribution. The calculation is as follows:
$100,000 in an existing traditional IRA
$6,500 after tax contribution (to be converted to a Roth via the “backdoor”)
28% marginal tax rate
Divide the after tax IRA dollars ($6,500) by the total IRA dollars ($106,500) to obtain the tax-free portion of the after tax dollars.
$6,500/$106,500= 6.1%. $6,500 x .061 =$396.71 (tax free)
The remainder $6,103.29 ($6,500-$396.71) is taxed at Joe’s marginal tax rate.
At a 28% marginal rate the pro rata taxes are $1,708.92 ($6,103.29 x .28)
If Joe’s marginal bracket is 28%, he will pay a pro-rata tax of $1,708.92 on the contribution. Remember that the $6,500 contribution was made with AFTER tax dollars. To generate an after tax income of $6,500, Joe would pay $2,527.78 in taxes.
$9,027.78 x (1-0.28)= $6,500 The after tax contribution
$9,027.78-$6,500 = $2,527.78 Taxes paid to generate an after tax income of $6,500
Joe’s total taxes paid for his $6,500 backdoor Roth:
$4,236.70 = $2,527.78 (taxes paid to produce $6,500) + $1,708.92 (pro rata tax)
Joe pays a total tax bill of $4,236.70 on the contribution of $6,500. For most people, this makes the backdoor Roth uneconomical.
Backdoor Roths can be an excellent way for high-income people to contribute to Roths, but be aware that if you have any existing IRAs, this option may not be for you. It makes sense to consult with your tax advisor before employing this somewhat complex strategy.