Back Door Roth IRA Rules and Steps

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 401(k) plan. Fortunately, this isn’t true.

While direct contributions to a Roth IRA are limited to taxpayers with income in excess of $120,000 ($189,000 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. Our IRA company – Directed IRA – can help those who want a self-directed “back door” Roth IRA, but the strategy can be done with almost anyone who wants a Roth IRA.

Examples

Here’s a few examples of earners who can establish and fund a Roth IRA:

  1. “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. You just have to use the “back door” method.
  2. “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 $189,000 for married taxpayers and $120,000 for single taxpayers. You just have to use the “back door” method.

The Process

The strategy used by high-income earners to make Roth IRA contributions involves the deposit 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 on the amounts contributed, but the funds are held in a Roth IRA and are 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 has a spouse who does) can’t also make “deductible” contributions to an IRA. However, the account can be funded by non-deductible amounts up to the IRA annual contribution amounts of $5,500 for 2018 ($6,000 for 2019 and forward). 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 made the 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 limit 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, all taxpayers are able to covert traditional IRA funds to Roth IRAs since 2010. 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 tens of 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 SEP 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 $95,000, 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 convert 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 workarounds 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 rollover your Traditional IRA funds into that 401(k) plan. Most 401(k) plans allow 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 rollover your Traditional IRA 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, so plan carefully.

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.

Maxed Out Your 401(k), What’s Next?

Photo of graffiti on the ground reading as "What's Next?"For most American workers and business owners, the first vehicle to save and invest in is your 401(k). The tax benefits and the typical company matching that offers free company money make a 401(k) a great place to save and invest for the long-haul. But what if you’ve maxed out your 401(k) contributions? What else can you do?

Here are the three options you should consider that provide significant tax and financial benefits:

1. Back-Door Roth IRA

This is a really cool option that many clients utilize every year. (I do too.) First, you may be thinking that you can’t do a Roth IRA because your income is too high or because you already maxed out your 401(k). WRONG: It is still possible to do a Roth IRA, but you just have to know the back-door route. The reason it’s called a back-door Roth IRA is because you make a non-deductible traditional IRA contribution (up to $5,500 annual limit, $6,500 if 50 or older). Then, after the non-deductible traditional IRA contribution is made, you then convert the funds to Roth. There is no income limit on Roth conversions, and since you didn’t take a deduction on the non-deductible traditional IRA contribution, there is no tax due on the conversion to Roth. And now, voila, you have $5,500 in your Roth IRA. That’s the back-door route.

There is a road block though for some who already have funds already in traditional IRAs. The Roth conversion ordering rules state that you must first convert your pre-tax traditional IRA funds, which you got a deduction for and now pay tax when you convert, before you are able to convert the non-deductible traditional IRA funds. So, if you have pre-tax traditional IRA funds and you want to do the back-door Roth IRA, you have two options:

  1. First, convert those pre-tax traditional IRA dollars to Roth and pay the taxes on the conversion.
  2. Second, if your 401(k) allows, you can roll those pre-tax traditional IRA dollars into your 401(k). If you don’t have a traditional IRA, you’re on easy street and only need to do the two-step process of making the non-deductible traditional IRA contribution and then convert it to Roth.

You have until April 15th of each year to do this for the prior tax year. Additionally, while the GOP tax-reform restricted Roth re-characterizations, Roth conversions and the back-door Roth IRA route were unaffected. For more detail on the back-door Roth IRA, check out my prior article here.

2. Health Savings Account (HSA)

If you have a high-deductible health insurance plan, you can make contributions to your HSA up until April 15th of each year for the prior tax year. Why make an HSA contribution? Because you get a tax deduction for doing it, and because that money comes out of your HSA tax-free for your medical, dental, or drug costs. You can contribute and get a deduction, above the line, of up to $3,400 if you’re single or for up to $6,750 for family. We all have these out-of-pockets costs, and this is the most efficient way to spend those dollars (from an account you got a tax deduction for putting money into). If you didn’t have a high deductible HSA-qualifying plan by December 1st of the prior year, then the HSA won’t work.

Any amounts you don’t spend on medical can be invested in the account and grow tax-free for your future medical or long-term care. Health savings accounts can also be invested and self-directed into real estate, LLCs, private companies, crypto-currency or other alternative assets. We’ve helped many clients invest these tax-favored funds using a self-directed HSA.

For more details on health savings accounts, check out my partner Mark’s article here.

3. Cash Balance Plan or Defined Benefit Plan

If you’re self-employed you may consider establishing a cash balance plan or a defined benefit plan (aka “pension”), where you can possibly contribute hundreds of thousands of dollars each year. The amount of your contribution depends on your income, age, and the age and number of employees you may have. A cash balance plan or defined benefit plan/pension will cost you ten thousand dollars or more in fees to establish, and is far more expensive to maintain and administer. But, if you have the income, it’s a valuable option to consider. For more details on cash balance plans, check out Randy Luebke’s article here.

2014 Retirement Plan Contribution Deadlines: Start Planning Now & Don’t Get Left Behind

Photo of a clock on a wall with the text "2014 Retirement Plan Contribution Deadlines Start Planning Now & Don’t Get Left Behind."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 IRAContribution TypeDeadline Details
Traditional IRATraditional, DeductibleApril 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 IRARoth, Not DeductibleApril 15, 2015, Due Date for Individual Tax Return Filing (not including extensions). IRC § 408A(c)(7).
SEP IRA EmployeeN/A; employee contributions cannot be made to a SEP IRA plan.
Employer ContributionMarch 15/April 15th, Due Date for Company Tax Return Filing (including extensions).  IRC § 404(h)(1)(B).
Simple IRA Employee Elective DeferralJanuary 30, 2015.  IRC § 408(p)(5)(A)(i).
Employer ContributionMarch 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 StructureType of Cont.Deadline Details
401(k), including self-directed Solo 401(k) (plan must be adopted by 12/31/14)Sole ProprietorshipEmployee Elective DeferralContributionApril 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 ContributionApril 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-CorporationEmployee Elective Deferral contributionMarch 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 ContributionMarch 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 ContributionApril 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 ContributionApril 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.