There are 25 trillion dollars in retirement plans in the United States. Do you know that these funds can be invested into your business? Yes, it’s true, IRAs and 401(k)s can be used to invest in start-ups, private companies, real estate, and small businesses. Unfortunately, most entrepreneurs and retirement account owners didn’t even know that retirement accounts can invest in private companies but you’ve been able to do it for over 30 years.
Think of who owns these funds: It’s everyday Americans, it’s your cousin, friend, running partner, neighbor…it’s you. In fact, for many Americans, their retirement account is their largest concentration of invest-able funds. Yet, you’ve never asked anyone to invest in your business with their retirement account. Why not? How much do you think they have in their IRA or old employer 401(k)? How attached do you think they are to those investments? These are the questions that have unlocked hundreds of millions of dollars to be invested in private companies and start-ups.
How Many People Are Doing This?
Recent industry surveys revealed that there are one million retirement accounts that are self-directed into private companies, real estate, venture capital, private equity, hedge funds, start-ups, and other so-called “alternative” investments. It is a sliver of the overall retirement account market, but it’s growing in popularity.
So, how does it work? How can these funds be properly invested into your business? If you ask your CPA or lawyer, the typical response is, “It’s possible, but very complicated, so we don’t recommend it.” In other words, they’ve heard of it, but they don’t know how it works, and they don’t want to look bad guessing. If you ask a financial adviser, particularly your own, they’ll talk about how it’s such a bad idea while thinking about how much fees they’ll lose when you stop buying mutual funds, annuities, and stocks that they make commissions or other fees from. Well, not all financial advisers, but unfortunately too many do.
Now, there are some legal and tax issues that need to be complied with, but that’s what good lawyers and accounts are for, right? And yes, there is greater risk in private company or start-up investments so self-directed IRA investors need to conduct adequate due diligence and they shouldn’t invest all of their account into one private company investment. So how does it work?
What is a Self-Directed IRA?
In order to invest into a private company, start-up, or small business, the retirement account holder must have a self-directed IRA? So, what is a self-directed IRA? A self-directed IRA is a retirement account that can be invested into any investment allowed by law. If your account is with a typical IRA or 401(k) company, such as Fidelity, Vanguard, TD Ameritrade, Merrill Lynch, Charles Schwab, then you can only invest in investments allowed under their platform, and these companies deem private company investments as “administratively unfeasible” to hold so they won’t allow your IRA or 401(k) to invest in them (some make exceptions for ultra-high net-worth clients, $50M plus accounts). As a result, the first step when investing in a private company with retirement account funds is to rollover or transfer the funds, without tax consequence, to a self-directed custodian who will allow your IRA, Roth IRA, SEP IRA, HSA, or Solo 401(k) to be invested into a private company. There are over 30 companies who provide self-directed IRAs. For a detailed list of the companies that provide these types of accounts, check out the Retirement Industry Trust Association’s website and membership list. RITA is the national association for the self-directed retirement plan industry, and most major companies who provide these accounts are members of RITA.
Legal Tip: If an investor’s retirement account is with their current employer’s retirement plan (e.g. 401(k)), they won’t be able to change their custodian until they leave that employer or until they reach retirement age (59.5 years old). So, for now, they’re 401(k) is usually limited to buying mutual funds they don’t understand and don’t want.
Sell Corporation Stock or LLC Units to Self-Directed IRAs
Are you seeking capital for your business in exchange for stock or other equity? If so, you should consider offering shares or units in your company to retirement account owners. You don’t need to wait until your company is publicly traded to sell ownership to retirement accounts. Here are a few well-known companies who had individuals with self-directed IRAs invest in them before they were publicly traded: Facebook, Staples, Sealy, PayPal, Domino’s, and Yelp, just to name a few.
You can also raise capital for real estate purchases or equipment whereby a promissory note is offered to the IRA investor who acts as lender, and the funds are usually secured by the real estate or equipment being purchased. There are many investment variations available, but the most common is an equity investment purchasing shares or units where the IRA becomes a shareholder or note investment whereby the IRA becomes a lender. Keep in mind, you need to comply with state and federal securities laws when raising money from any investor.
Need to Know #1: Prohibited Transactions
There are two key rules to understand when other people invest their retirement account into your business. First, the tax code restricts an IRA or 401(k) from transacting with the account owner personally or with certain family (e.g. parents, spouse, kids, etc.). This restriction is known as the prohibited transaction rule. See IRC 4975 and IRS Pub 590A. Consequently, if you own a business personally you can’t have your own IRA or your parents IRA invest into your company to buy your stock or LLC units. However, more distant family members such as siblings, cousins, aunts and uncles could move their retirement account funds to a self-directed IRA to invest in your company. And certainly, unrelated third-parties would not be restricted by the prohibited transaction rules from investing in your company. What if you are only one of the founders or partners of a business, and you want to invest your IRA or your spouse’s IRA into the company? This is possible if your ownership and control is below 50%, but this question is very complicated and nuanced, so you’ll want to discuss it with your attorney or CPA who is familiar with this area of the tax law.
If a prohibited transaction occurs, the self-directed IRA is entirely distributed. That’s a pretty harsh consequence and one that makes compliance with this rule critical.
Need to Know #2: UBIT Tax
The second rule to understand is a tax known as Unrelated Business Income Tax (“UBIT”, aka, “UBTI”). UBIT is a tax that can apply to an IRA when it receives “business” income. IRAs and 401(k)s don’t pay tax on the income or gains that go back to the account so long as they receive “investment” income. Investment income would include rental income, capital gain income, dividend income from a c-corp, interest income, and royalty income. If you’ve owned mutual funds or stocks with your retirement account, the income from these investments always falls into one of these “investment” income categories. However, when you go outside of these standardized forms of investment, you can be outside of “investment” income and you just might be receiving “business” income that is subject to the dreaded “unrelated business income tax.” This tax rate is at 39.6% at $12,000 of taxable income annually. That’s a hefty rate, so you want to make sure you avoid it or otherwise understand and anticipate it when making investment decisions. The most common situation where a self-directed IRA will become subject to UBIT is when the IRA invests into an operational business selling goods or services who does not pay corporate income tax. For example, let’s say my new business retails goods on-line, and is organized as an LLC and taxed as a partnership. This is a very common form of private business and taxation, but one that will cause UBIT tax for net profits received by self-directed IRA. If, on the other hand, the same new business was a c-corporation and paid corporate tax (that’s what c-corps do), then the profits to the self-directed IRA would be dividend income, a form of investment income, and UBIT would not apply. Consequently, self-directed IRAs should presume that UBIT will apply when they invest into an operational business that is an LLC, but should presume that UBIT will not apply when they invest into an operational business that is a c-corporation.
Legal Tip: IRAs can own c-corporation stock, LLC units, LP interest, but they cannot own s-corporation stock because IRAs and 401(k)s do NOT qualify as s-corporation shareholders.
Now, if you’re an LLC raising capital from other people’s IRAs or 401(k)s, you should have a section in your offering documents that notifies people of potential UBIT tax on their investment. UBIT tax is paid by the retirement account annually on the net profits the account receives so it doesn’t cost the company raising the funds any additional money or tax. It costs the retirement account investor since UBIT is paid by the retirement account. Despite the hefty tax, many IRAs and 401(k)s will still invest when UBIT is present as they may be willing to pay the tax on a well-performing investment or their investment strategy. Alternatively, many self-directed IRAs may be investing with an intent to sell their ownership in the LLC as the mechanism to receive their planned return on investment. When selling their LLC ownership, the gain in the LLC units would be capital gain income and would not be subject to UBIT.
If the investment from the self-directed IRA was via a note or other debt instrument, then the profits to the IRA are simply interest income and that income is always investment income and is not subject to UBIT tax. Many companies raise capital from IRAs for real estate purchases or for equipment purchases. These loans from an IRA or IRA(s) are often secured by the real estate or equipment being purchased and the IRA ends up earning interest income like a private lender.
So, here’s a brief summary of what we’ve learned. First, there’s $25 trillion in retirement plans in the U.S. These retirement accounts can be used to invest into your start-up or private company. You need to comply with the prohibited transaction rules and you can’t invest your own account or certain family member’s account into your business as that would invalidate the IRA. But everyone else’s IRA can invest into your company. And lastly, depending on how the company is structured (LLC or C-Corp), and how the investment is designed (equity or debt/loan), there may be UBIT tax on the profits from the investment. Remember, UBIT tax usually arises for IRAs in operating businesses structured as LLCs where the company doesn’t pay a corporate tax on their net profits. This income is pushed down to the owners and in the case of an IRA this can cause UBIT tax liability.
Here’s the bottom line, retirement account funds can be a significant source of funding and investment for your business, so it’s worth some time and effort to learn how these funds can most efficiently be utilized. While there are some rules unique to retirement accounts they can easily be understood and planned for.
A Joint Venture Agreement (aka, “JV Agreement”) is a document many business owners and investors should become familiar with. In short, a JV Agreement is a contract between two or more parties where the parties outline the venture, who is providing what (money, services, credit, etc.), what the parties responsibility and authority are, how decisions will be made, how profits/losses are to be shared, and other venture specific terms.
A joint venture agreement is typically used by two parties (companies or individuals) who are entering into a “one-off” project, investment, or business opportunity. In many instances, the two parties will form a new company such as an LLC to conduct operations or to own the investment and this is usually the recommended path if the parties intend to operate together over the long term. However, if the opportunity between the parties is a “one-off” venture where the parties intend to cease working together once the agreement or deal is completed, a joint venture agreement may be an excellent option.
For example, consider a common JV Agreement scenario used by real estate investors. A real estate investor purchases a property in their LLC or s-corporation and intends to rehab and then sell the property for a profit. The real estate investors finds a contractor to conduct the rehab and the arrangement with the contractor is that the contractor will be reimbursed their expenses and costs and is then paid a share of the profits from the sale of the property following the rehab. In this scenario, the JV Agreement works well as the parties can outline the responsibilities and how profits/losses will be shared following the sale of the property. It is possible to have the contractor added to the real estate investors s-corporation or LLC in order to share in profits, but that typically wouldn’t be advisable as that contractor would permanently be an owner of the real estate investor’s company and the real estate investor will likely use that company for other properties and investments where the contractor is not involved. As a result, a JV Agreement between the real estate investors company that owns the property and the contractors construction company that will complete the construction work is preferred as each party keeps control and ownership of their own company and they divide profits and responsibility on the project being completed together.
While a new company is not required when entering into a JV Agreement, many JV Agreements benefit from having a joint venture specific LLC that is created just for the purpose of the JV Agreement. This venture specific LLC is advisable in a couple of situations. First, where the parties do not have an entity under which to conduct business and which will provide liability protection. In this instance, a new company should be formed anyways for liability purposes and depending on the parties future intentions a new LLC between the parties may work well. Second, where the arrangement carries significant liability, capital, or other resources. The more money, time, and liability involved in the venture will give more reason to having a separate new LLC to own the new venture and to isolate liability, capital, and other resources. A $1M deal or venture could be done with a JV Agreement alone, however, the parties would be well advised to establish a new entity as part of the JV Agreement. On the other hand, if the venture is only a matter of tens of thousands of dollars, the costs of a new entity may outweigh the benefits of a separate LLC for the venture.
There are numerous scenarios where JV Agreements are used in real estate investments, business start-ups, and in other business situations. Careful consideration should be made when entering into a JV Agreement and each Agreement is always unique and requires some special tailoring.
IRAs are the most commonly held retirement account and annuities are one of the most popular investments for retirees. Despite the popularity of each, the two concepts shouldn’t ordinarily be combined together. On the topic of IRAs and annuities, I am routinely asked the following questions.
- Can I buy an annuity with my IRA?
- Should I buy an annuity with my IRA?
- How do I get out of an annuity I bought with my IRA?
- Can I roll-over my annuity IRA to a self-directed IRA?
In this article I’ll answer each question, but before I do, let me first explain how an annuity works as it is essential to understanding the questions and your options. IRS Publication 939 is helpful in explaining the annuity tax rules and can be found here.
An annuity is an insurance product you can purchase whereby you invest funds with the annuity insurance company and they agree to make payments to you for the rest of your life or for a set period of years. The typical candidates of annuities are retirees seeking a guaranteed steady stream of income. The retiree gives up their cash now in exchange for payments back from the insurance company over time. There are many different types of annuities but the two most common are fixed annuities and variable annuities. In a fixed annuity, the insurance company agrees to pay you back based on a fixed payment schedule. Under a variable annuity, the insurance company agrees to pay you back based on the performance of the annuity investment (you have some limited choices in how those funds are invested in a variable annuity).
An annuity can begin paying you back immediately or it can be invested over a period of time and grow tax deferred and then later pay you out at retirement age. The income from an annuity is taxed as it is received by the annuity owner. Typically, when you receive payments from an annuity you personally own (outside a retirement account), a portion of the payment is taxable (the income/growth part) and the portion that is a return of your investment or premium is not taxable. The portion of the annuity payment that is taxable is subject to ordinary income tax rates.
One of the benefits of an annuity is that the funds grow in the annuity tax deferred with the funds compounding and without having to pay tax on any income the IRS. When you start receiving payments from the annuity, the funds you invested into the annuity are not taxed but the earnings are taxed.
No Contribution Limits
When you purchase an annuity outside of a retirement account such as an IRA, you can invest as much money as you want and you are not limited to annual contribution limits like you are with IRAs or 401(k)s. So, for example, if you want to buy a $250,000 annuity with $250,000 of cash, then you can make that investment all in one-year. You are not subject to $5,500 annual contribution limits.
If you take funds from an annuity before you’re 59 ½, you’re subject to a 10% early withdrawal penalty on any taxable earnings. Any investment gains (above your initial investment) are also subject to tax and must be included as regular income on your personal tax return.
When you own an annuity you will typically have an account value for that annuity and if you decide to “cash-out” the annuity, instead of receiving the scheduled payments, you will likely be subject to a surrender charge. The surrender charge differs amongst annuity products and companies but the most common penalty is a 7% surrender charge during your first couple of years and then it goes down 1% each year until it is removed. So, if you have only had an annuity for a few years it is likely that you will have to pay the insurance company a surrender charge in order to “cash-out” the annuity. If you have had an annuity for ten years or longer, you are likely able to “cash-out” the annuity without penalty.
IRAs and Annuities
Now that we have the basics of annuities out of the way, let’s get to the questions about annuities and IRAs.
1. Can I buy an annuity with my IRA?
Yes, you can purchase an annuity with your IRA. However, just because you can doesn’t mean that you should. In my opinion, annuities can be part of a well structured financial plan but should be purchased with non- retirement plan (e.g. IRA) funds.
2. Should I buy an annuity with my IRA?
Probably not. One of the benefits of an annuity is that it gives you tax-deferral on the income that is being generated and as a result, using an IRA where you already obtain tax-deferral just doesn’t seem to make sense. If you like the annuity concept of fixed and guaranteed payments, albeit with modest gains from your principal, then you should consider an annuity with your non-retirement plan funds as those dollars aren;t getting any special treatment under the tax code when they are invested. If you already have a large nest-egg of retirement plan funds, why use that set of tax favorable funds to buy an investment product that you could buy with non-retirement plan funds and receive the same tax-treatment. Some say that buying an annuity with an IRA is like wearing a belt and suspenders since your money is already tax-deferred in a traditional IRA. Secondly, annuities are subject to surrender charges and as a result you are locked into that investment and face surrender penalties at the investment level (let alone the account level) if you want to get money out of the annuity to invest in something else or for personal use.
3. How do I get out of an annuity bought with my IRA?
You can usually “cash-out” your annuity owned by your IRA, however, cashing out the annuity to the account value will typically cause a surrender charge. Most annuities have a surrender charge during the first 7 years or so, whereby the penalty is 7% for the first year or two and then decreases 1 percent each year until it is removed. Check with you annuity company or financial advisor in your specific situation though as the products and surrender charges do vary. If you “cash-out” an annuity owned with IRA funds and if those funds are returned to an IRA, then there is no taxable distribution or tax penalty. The only “penalty” would be the surrender penalty by the annuity insurance company. If you take the cash personally though, instead of sending it to your IRA, then those funds are subject to the regular IRA distribution rules and as a result you could be subject to taxes and early withdrawal penalties on the amounts received.
4. Can I roll-over my annuity IRA to a self-directed IRA?
Yes. You can roll-over your annuity IRA to a self-directed IRA. You’ll need to “cash-out” the IRA, pay any applicable surrender charges, and then instruct the annuity company to process a direct roll-over of the funds to your self-directed IRA custodian as a direct rollover. This rollover will NOT be subject to taxes or penalties. Keep in mind though, there may be a surrender penalty though with the annuity company. If there is a surrender penalty, you’ll want to determine whether the benefit and payments owed under the annuity are worth hanging on to the annuity investment or if you are better off simply paying the penalty and moving on to other investment options.
Unfortunately, the annuity and IRA rules can be a little tricky, but once understood you can make informed decisions about how to best use and invest your retirement dollars.
Retirement account/plan contributions are one of the most powerful tax strategies you can implement but you’ve got to make them by the deadline so that they can reduce this years tax liability. With the end of the year fast approaching, now is the time to make certain you are maximizing this important tax strategy for your 2014 tax planning. Please find below a table outlining the deadlines for 2014 retirement plan contributions according to your type of retirement account. If you are self-employed, you’ll notice the deadline also may depend on the type of company you own (e.g. s-corp or LLC) but also whether you are making contributions as an employee of your company and/or as the employer. First, let’s summarize the IRA contribution deadlines.
IRA Contribution Deadlines
|Type of IRA||Contribution Type||Deadline Details|
|Traditional IRA||Traditional, Deductible||April 15, 2015, Due Date for Individual Tax Return Filing (not including extensions). IRC § 219(f)(3); You can file your return claiming a contribution before the contribution is actually made. Rev. Rul. 84-18.|
|Roth IRA||Roth, Not Deductible||April 15, 2015, Due Date for Individual Tax Return Filing (not including extensions). IRC § 408A(c)(7).|
|SEP IRA ||Employee||N/A; employee contributions cannot be made to a SEP IRA plan.|
|Employer Contribution||March 15/April 15th, Due Date for Company Tax Return Filing (including extensions). IRC § 404(h)(1)(B).|
|Simple IRA ||Employee Elective Deferral||January 30, 2015. IRC § 408(p)(5)(A)(i).|
|Employer Contribution||March 15/April 15, Due Date for Company Tax Return Filing (including extensions). IRC § 408(p)(5)(A)(ii).|
In summary, for traditional and roth IRA contributions you have until the individual tax return deadline of April 15, 2015 to make 2014 contributions. SEP and SIMPLE IRA contribution deadlines are based on the company tax return deadline which could be March 15th if the company is a corporation and April 15th if it is a sole proprietorship or partnership. Keep in mind that this deadline does NOT include extensions so even if you extend your personal tax return filing to September 15, 2015, you still have a April 15, 2015, contribution deadline for Roth and Traditional IRAs.
401(k) Contribution Deadlines
|Solo 401(k)||Business Structure||Type of Cont.||Deadline Details|
|401(k), including self-directed Solo 401(k) (plan must be adopted by 12/31/14)||Sole Proprietorship||Employee Elective DeferralContribution||April 15, 2015, contribution deadline is Due Date for Employer Tax Return (including extensions) but compensation must have been earned by December 31, 2014 and election should be made by December 31, 2014; IRS Publication 560. Rev. Rul. 76-28; 90-105.|
|Employer Profit Sharing Contribution||April 15, 2015, Due Date for Company Tax Return Filing, including extensions, however employee compensation must have been earned by December 31, 2014. IRC § 404(a)(6). Rev. Rul. 76-28; 90-105.|
|S-CorporationOr C-Corporation||Employee Elective Deferral contribution||March 15, 2015 (corporation filing deadline), contribution deadline is Due Date for Employer Tax Return (including extensions) but compensation must have been earned by December 31, 2014 and election should be made by December 31, 2014; IRS Publication 560. Rev. Rul. 76-28; 90-105.|
|Employer Profit Sharing Contribution||March 15, 2015, Due Date for Company Tax Return Filing, including extensions, however employee compensation must have been earned by December 31, 2014. IRC § 404(a)(6). Rev. Rul. 76-28; 90-105|
|Partnership (e.g. partnership LLC)||Employee Elective Deferral Contribution||April 15, 2015 (partnership return filing deadline), contribution deadline is Due Date for Employer Tax Return (including extensions) but compensation must have been earned by December 31, 2014 and Election should be made by December 31, 2014; IRS Publication 560. Rev. Rul. 76-28; 90-105.|
|Employer Profit Sharing Contribution||April 15, 2015, Due Date for Company Tax Return Filing, including extensions, however employee compensation must have been earned by December 31, 2014. IRC § 404(a)(6). Rev. Rul. 76-28; 90-105.|
There are a few important things to keep in mind regarding 401(k) contributions.
401(k) Contribution Deadlines Can Be Extended
First, the contribution deadline for employer and employee contributions is the company tax return deadline INCUDLING extensions. So, if you have a solo 401(k) you can extend your company tax return and your contribution deadline is also automatically extended. For example, if you have a solo 401(k) plan adopted by your s-corporation, then your s-corporation tax return deadline is March 15, 2015, but that can be extended 6 months until September 15, 2015, upon filing an extension to extend the company tax return with the IRS. If you do this, you’d have until September 15, 2015, to make the 2014 employee and employer contributions. That being said, the employee contributions are taken from your salary/wages and if you make traditional 401(k) employee contributions those amounts are reported on your personal W-2 and reduce your taxable wages. The W-2 is effectively where your tax deduction for traditional employee contribution arises is it reduces your taxable wages on your W-2. As a result, you’ll need to make or at least know the amount you intend to make for employee contributions by January 31, 2015 as that is the W-2 filing deadline for 2014.
New 401(k)s Must Be Adopted by December 31st
Second, if you are establishing a new Roth or Traditional IRA, you can create that new account at the time of the IRA contribution deadline. However, if you are establishing a new solo 401(k) plan, you must have the plan established by December 31, 2014. Because there are a number of documents and procedures required to create a new 401(k) plan, this is not something that can be left to the last minute and you should start immediately if you intend to open a 401(k) this year.
Make 2014 Contributions in 2014
And lastly, while the deadlines for most 2014 retirement plan contributions for IRAs and 401(k)s runs into 2015, to keep things simple and stress-free we recommend making 2014 contributions by December 31, 2014, when possible.
As you can see, the contribution deadlines vary depending on the type of account/plan but also on the type of contribution. With respect to contributions to a self-directed solo 401(k), the contribution deadline also varies depending on the type of company you own that has adopted the plan. Therefore, it is important that you understand these deadlines and don’t miss out on an opportunity to maximize your tax deductions. For guidance on the contribution limits in 2014, please click here.
As previously stated, it is not too late to setup a retirement account/plan if you have not done so already. The deadline to set up a 401(k) and to make contributions for 2014 is typically the last day of the year, although I wouldn’t wait until the last day or even the last week of the year to do so. If you are interested in setting up a self-directed solo 401(k), please contact us immediately as we are helping clients establish these and so that we can get it set up before the end of the year.
Roth IRAs can be established and funded for high-income earners by using what is known as the “back door” Roth IRA contribution method. Many high-income earners believe that they can’t contribute to a Roth IRA because they make too much money and/or because they participate in a company 401k plan. Fortunately, this thinking is wrong. While direct contributions to a Roth IRA are limited to taxpayers with income in excess of $129,000 ($191,000 for married taxpayers), those whose income exceeds these amounts may make annual contributions to a non-deductible traditional IRA and then convert those amounts over to a Roth IRA.
Here’s a few examples of earners who can establish and fund a Roth IRA.
- I’m a high-income earner and work for a company who offers a company 401(k) plan. I contribute the maximum amount to that plan each year. Can I establish and fund a Roth IRA? Yes, even though you are high-income and even though you participate in a company 401(k) plan, you can establish and fund a Roth IRA.
- I’m self-employed and earn over $200,000 a year; can I have a Roth IRA? Isn’t my income too high? Yes, you can contribute to a Roth IRA despite having income that exceeds the Roth IRA income contribution limits of $191,000 for married taxpayers and $129,000 for single taxpayers.
The strategy used by high-income earners to make Roth IRA contributions involves the making of non-deductible contributions to a traditional IRA and then converting those funds in the non-deductible traditional IRA to a Roth IRA. This is often times referred to as a “back door” Roth IRA. In the end, you don’t get a tax deduction the amounts contributed but the funds are held in a Roth IRA and grow and come at tax-free upon retirement (just like a Roth IRA). Here’s how it works.
Step 1: Fund a new non-deductible traditional IRA
This IRA is “non-deductible” because high-income earners who participate in a company retirement plan (or who have a spouse who does) can’t also make “deductible” contributions to an IRA. The account can, however, be funded by non-deductible amounts up to the IRA annual contribution amounts of $5,500. The non-deductible contributions mean you don’t get a tax deduction on the amounts contributed to the traditional IRA. Don’t worry about having non-deductible contributions though as you’re converting to a Roth IRA so you don’t want a deduction for the funds contributed. If you did get a deduction for the contribution, you’d have to pay taxes on the amounts later converted to Roth. You’ll need to file IRS form 8606 for the tax year in which you make non-deductible IRA contributions. The form can be found here.
If you’re a high-income earner and you don’t have a company based retirement plan (or a spouse with one), then you simply establish a standard deductible traditional IRA, as there is no high-income contribution limitation on traditional IRAs when you don’t participate in a company plan.
Step 2: Convert the non-deductible traditional IRA funds to a Roth IRA
In 2010, the limitations on Roth IRA conversions, which previously restricted Roth IRA conversions for high-income earners, was removed. As a result, since 2010 all taxpayers are able to covert traditional IRA funds to Roth IRAs. It was in 2010 that this back door Roth IRA contribution strategy was first utilized as it relied on the ability to convert funds from traditional to Roth. It has been used by thousands of Americans since.
If you have other existing traditional IRAs, then the tax treatment of your conversion to Roth becomes a little more complicated as you must take into account those existing IRA funds when undertaking a conversion (including SEPs and SIMPLE IRAs). If the only IRA you have is the non-deductible IRA, then the conversion is easy because you convert the entire non-deductible IRA amount over to Roth with no tax on the conversion. Remember, you didn’t get a deduction into the non-deductible traditional IRA so there is not tax to apply on conversions. On the other hand, if you have an existing IRA with say $95,000 in it and you have $5,000 in non-deductible traditional IRA contributions in another account that you wish to convert to Roth, then the IRS requires you to covert over your IRA funds in equal parts deductible (the $95K bucket) and non-deductible amounts (the new $5K) based on the money you have in all traditional IRAs. So, if you wanted to convert $10,000, then you’d have to convert $9,500 (95%) of your deductible bucket, which portion of conversion is subject to tax, and $500 of you non-deductible bucket, which isn’t subject to tax upon once converted. Consequently, the “back door” Roth IRA isn’t well suited when you have existing traditional IRAs that contain deductible contributions and earnings from those sums.
There are two work-arounds to this Roth IRA conversion problem and both revolve around moving the existing traditional IRA funds into a 401(k) or other employer based plan as employer plan funds are not considered when determining what portions of the traditional IRAs are subject to tax on conversion (the deductible AND the non-deductible). If you participate in an existing company 401(k) plan, then you may roll over your traditional IRA funds into that 401(k) plan. Most 401(k) plans allows for this rollover from IRA to 401(k) so long as you are still employed by that company. If you are self-employed, you may establish a solo or owner only 401(k) plan and you can roll over your traditional IRA dollars into this 401(k). In the end though, if you can’t roll out existing traditional IRA funds into a 401(k), then the “back door” Roth IRA is going to cause some tax repercussions, as you also have to convert a portion of the existing traditional IRA funds, which will cause taxes upon conversion. Taxes on conversion aren’t “the end of the world” though as all of the money that comes out of that traditional IRA would be subject to tax at some point in time. The only issue is it causes a big tax bill now so careful planning must be taken.
The bottom line is that Roth IRAs can be established and funded by high-income earners. Don’t consider yourself “left out” on one of the greatest tax strategies offered to Americans: the Roth IRA.