A reader Bob, recently asked about contributing to a Roth IRA after he maxed out his 401k. For most people, yes, as long as you qualify for the IRA, you can contribute to and max out both a Roth IRA and your 401k.
However, Bob has a high income and the Roth IRA eligibility phases out for single filers between $118,000 to $133,000 ($186,000 to $196,000 for married) for 2017. Because Bob’s income is over the income limits, he is ineligible to contribute to a Roth IRA directly.
There is a workaround, however, which is nicknamed the Backdoor Roth IRA.
What is a Backdoor Roth IRA?
A backdoor Roth IRA is a roundabout way to contribute to a Roth IRA when you normally aren’t allowed to using a combination of a traditional IRA contribution and a Roth IRA conversion.
In 2010, the income limits on Roth conversions were lifted. Now, you can contribute to a traditional IRA, which doesn’t limit contributions based on your income, only the ability to deduct those contributions. Then you can convert it to a Roth IRA immediately. You won’t owe taxes on the conversion since you initially funded a non-deductible traditional IRA using after tax money. The basis of your IRA will be the full amount of the contribution.
Backdoor Roth IRA Steps
Here is how to take advantage of the Backdoor Roth IRA:
- Open a traditional IRA at your broker of choice.
- Contribute to your nondeductible traditional IRA up to the IRA Limits.
- Make a Roth IRA Conversion.
- Report the transactions on Form 8606.
Pro-Rata Tax Stumbling Blocks
Pro-rata calculations. If you have other money already in a traditional IRA, when you make a Roth IRA conversion for your backdoor IRA you must include a portion of tax-deferred money in the IRA in proportion to the amount held. For example, let’s say I have an IRA (including SEP-IRAs and SIMPLE IRAs) worth $100,000, with $50,000 (50%) tax deferred and $50,000 after tax. I complete a conversion of $20,000 to a Roth IRA. I will be responsible for taxes on $10,000, or 50%. You cannot specify to convert only the after-tax money in the account.
To avoid the Pro-rata stumbling block, you can use the Roth IRA Conversion Strategy to Avoid Taxes if your 401k provider allows transfers of IRA money. You can transfer your deductible IRA money to your 401k first, leaving you with only non-deductible money to convert.
Keep Track of your Roth IRA
Good luck with the Backdoor Roth IRA Bob! For anyone who is using this strategy, be sure to keep very good records! In fact, if you are using a Roth IRA in any form, you’ll need to track your contributions carefully: How to Track Your Roth IRA Contributions… and Why You Need To!