A couple months back, I worked with a reader named Peter (*Not his real name) who, as you might remember, had a lot of student loan debt and a high income. Among other things, I advised him to take a good hard look at some things he could cut from his budget and to aggressively pay down his debt.
Done and done.
The problem with Peter’s high income
We didn’t get too deep into retirement talk, but a commenter MoneyOCD pointed out that at Peter’s level of income, he would likely be ineligible to either contribute to a Roth IRA or to deduct contributions to a traditional IRA. A quick peek at the IRS charts of these income limits shows that he’s right:
- Because he makes more than $129,000, he can’t contribute to a Roth IRA at all.
- He can contribute to a traditional IRA, but because he makes more than $90,000, he can’t deduct those contributions.
You might think he should just keep his retirement funds in a taxable account because he’ll have to pay taxes on his gains anyway.
Lucky for Peter and other high earners, there’s another option.
The Backdoor Roth IRA
There’s a sole glimmer of light in the code for high earners like Peter looking to put away some tax-advantaged retirement savings in an IRA.
As of 2010, there has been no upper income limit to be eligible to convert funds in a traditional IRA into a Roth IRA, doing what most folks call a Roth conversion.
In practice, there’s a long complicated process to make this happen:
- Put money into a Traditional IRA
- Later, call up the financial institution that holds your Traditional IRA and Roth IRA accounts and tell them to move that money over
- Pay taxes on any earnings you move over
OK, maybe it’s not that complicated.
For Peter’s specific case, I don’t see any. He should put “Back door Roth” on his to-do list and go eat a peanut butter sandwich.
However, those who’ve been growing a Traditional IRA for many years should tread carefully. The IRS treats the amount being converted to a Roth IRA as though it came proportionally from the never-been-taxed portion (composed of earnings and pre-tax contributions) and the already-been-taxed portion (the non-deductible contributions made while your income was too high), and taxes accordingly. See IRS Publication 590 for more details, or I could go deeper into this in a future post if there’s interest.
Also, remember that all these instructions only apply if your income is too high to either deduct contributions to a traditional IRA or contribute to a Roth IRA the normal way (Check the charts again just to be sure). In Peter’s tax bracket, I’d obviously prefer a deductible pre-tax traditional IRA to a Roth — back door or otherwise — but since he’s not eligible to deduct contributions to a traditional IRA, we’re going with the next best option which is a Roth conversion rather than keeping it in non-deductible Traditional IRA money or holding it back in a taxable account.
Welp! This ended up pretty dense, but I hope it helped someone. Obviously, let me know if I can fill in more details and especially let me know if I made a mistake somewhere.
What’s been your experience with Roth conversions?