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.
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. You just have to use the “back door” method.
- “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 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.
All retirement account owners must be familiar with the required minimum distribution (“RMD”) rules applicable to their accounts. These rules require you, in most instances, to take partial distributions from your retirement account when you reach age 70 ½. And, surprise, the rules for Traditional IRAs, Roth IRAs, and 401(k)s differ. In fact, even 401(k)s where you are a 5% or greater owner have different rules than 401(k)s where you aren’t an owner. Thanks, Congress.
So what rules apply to Solo 401(k) owners? Well, generally speaking, you must begin taking distributions from your Solo K when you reach age 70 ½. Despite what you may think or presume, there are three quirks to be aware of when it comes to RMD and Solo 401(k):
Still Working Exception Does Not Work on Solo Ks
There is a general RMD 401(k) rule which states that even after age 70 ½, you are not required to take distributions from an employer 401(k) when you are still working for that employer. However, this exception does not apply to account holders or their spouses who own 5% or more of the company. In other words, business owners who use a Solo 401(k) will be forced to take RMD from their Solo 401(k) after age 70 ½ even if they are still working in the business.
Roth 401(k) Funds are Subject to RMD
RMD applies to Roth 401(k)s. I know what you’re thinking, “Wait, but why would RMDs apply to Roth 401(k)s when Roth IRAs are exempt?” Because Congress said so. I know, it doesn’t make much sense, Roth 401(k) distributions at retirement will be tax-free, like Roth IRA distributions, and the IRS will not receive any revenue from the distribution so why treat Roth 401(k)’s differently? There’s not a good answer, but you should write your Congressperson or Senator and ask. In the meantime, if you’re 70 ½ and you have funds in a Roth 401(k) which you don’t want distributed, you can roll those Roth 401(k) funds out to a Roth IRA and you can avoid the distribution requirement by letting those funds sit in your Roth IRA where no RMD is required. Checkmate, IRS.
Every 401(k) Must Have RMD Taken, No Aggregating
Every 401(k) account you have must take RMD. So, for example, if you have a Solo 401(k) and a 401(k) account with an old employer then you need to take RMD from each 401(k) account. You cannot aggregate those accounts together and take RMD out of one to satisfy both RMD requirements. This aggregating is allowed in Traditional IRAs but unfortunately does not work with different 401(k) plan accounts. If taking RMDs from multiple accounts is getting too complex, you can roll the old employer 401(k) to the Solo K or to a Traditional IRA (or Roth IRA if Roth 401(k) funds) to consolidate your accounts and your RMD requirements.
Make sure take RMD when you are required to do so. Failure to take RMD results in a 50% penalty tax on the amount you failed to take. As a result, it’s critical that you understand the RMD rules for each retirement account you hold. If you have made a mistake though, the IRS does have penalty waiver programs whereby you can correct some failed RMDs and request a waiver of the penalty due. This doesn’t work in every instance, but if you’ve failed to take RMD ask your tax lawyer or accountant on whether a penalty waiver could apply in your instance.
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:
- First, convert those pre-tax traditional IRA dollars to Roth and pay the taxes on the conversion.
- 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.
How does the proposed Republican tax reform impact your retirement account? Well, if you save for education expenses for your kids or grand-kids using a Coverdell Education Savings Account, you’re not going to be happy as new contributions to Coverdell accounts are eliminated in the House Plan. Also, both House and Senate bills eliminate the ability to re-characterize Roth IRA conversions back to Traditional IRAs. This was a nice “do-over” the IRS allowed you to use if you regretted converting your Traditional IRA to a Roth IRA, and switched it back to a traditional IRA within certain time limitations. For my prior article on how a Roth IRA re-characterization works, at least for now, check it out here.
The only good news: It could’ve been worse. There was talk of drastic changes that would have essentially called an end to Traditional IRA and 401(k) contributions in favor of Roth-only contributions (or limiting Traditional dollars to $2,400 annually). Luckily, those ideas never made it into the legislation.
Here’s a brief summary of the two major changes effecting IRAs. In addition to the changes effecting IRAs, there are numerous proposals regarding employer retirement plans such as 401(k)s, but those changes only slightly alter the ways those plans function.
|Source ||Change to IRAs||Effect|
|House Bill||No More Coverdell Education Savings Accounts (ESAs) Contributions||Coverdell accounts are used as a vehicle to contribute funds (up to $2k annually per beneficiary) for education expenses. It is usually used by parents or grandparents as an account to invest the money tax-free whereby the money in the account grows without being subject to tax and comes out tax-free for the beneficiary’s education expenses. There is no deduction for the contribution. The current proposal would eliminate the ability to make future Coverdell contributions. Existing accounts may still exist without new contributions or may be rolled to a 529.|
|House Bill & Senate Amendment to Senate Bill||End Roth IRA Re-characterizations||Under current rules, you can convert your traditional IRA to a Roth IRA, and if you later decide that such conversions (and tax due) wasn’t a good idea, you are allowed to undo the conversion and go back to a Traditional IRA.|
So what should you do now? If you’ve used Coverdell accounts or wanted to, make 2017 Coverdell contributions because they may be the last time you can do them. Also, if you’ve been thinking of converting a Traditional IRA to a Roth IRA, 2017 may be the last year you can do so, and still have the ability to re-characterize back to Traditional if you later decide against it.
You have until April 18th, 2017 to make 2016 IRA contributions for Roth and Traditional IRAs. If you’re self-employed and are using a SEP, your deadline is determined by your company’s tax filing deadline (e.g. s-corp, partnership, or sole prop). So, if you were an s-corp or partnership in 2016, then your filing deadline was March 15th, 2017. II you are a sole prop, then the deadline is April 18th, 2017. If you extended your company return, that extension will also apply to your SEP IRA contributions. The table below breaks down the deadlines and extension options for Traditional, Roth and SEP IRAs.
|Type of IRA||Contribution Type||Deadline Details|
|Traditional IRA||Traditional, Deductible||April 18th, 2017: 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 18th, 2017: Due Date for Individual Tax Return Filing (not including extensions). IRC § 408A(c)(7).|
|SEP IRA ||Employee, Deductible||N/A: Employee contributions cannot be made to a SEP IRA plan.|
|Employer Contribution, Deductible||March 15/April 15th: Due Date for Company Tax Return Filing (including extensions). IRC § 404(h)(1)(B).|
As outlined above, you have until the 2016 individual tax return deadline of April 18th, 2017 to make 2016 Traditional and Roth IRA contributions. The deadline for Traditional and Roth IRAs, however, does not include extensions. So, even if you extend your 2016 tax return, your 2016 Traditional and Roth IRA contributions are still due on April 18th, 2017.
SEP IRA contribution deadlines are based on the company tax return deadline, which could be March 15th if the company is taxed as a corporation (“c” or “s”) or partnership, and April 15th if it is a sole proprietorship. Keep in mind that this deadline includes extensions, so if you extend your company tax return filing, you will extend the time period to make 2016 SEP IRA contributions.