How to Contribute to a Tax Free Roth IRA if You Make Too Much Money

Troy Sharpe: The backdoor Roth IRA. This video is going to show you how to get around the IRS’s income limits if you make too much money to contribute to a traditional Roth IRA.

Hi, I’m Troy Sharpe, CEO of Oak Harvest Financial Group, CERTIFIED FINANCIAL PLANNER™ Professional (CFP®),  and host of the Retirement Income Show. The IRS puts income limits on the ability to contribute to a Roth IRA. If you haven’t seen my video about the Roth IRA,  please click on the little “i” right here, watch that video first, get a primer and then come back to this video.

The backdoor Roth IRA is for as long as we can do it and we can still do it now.  I don’t believe this will stay in effect forever, but we can get this done now if you make too much money to contribute to a normal Roth IRA . If your modified adjusted gross income is above $206,000, and you are married, you are disqualified from  contributing to a Roth IRA. If you’re a single filer, and your modified adjusted gross income is above $139,000, you also are disqualified from contributing  to a Roth IRA, but don’t fear.

We can still contribute to a Roth IRA through what is known as a backdoor  contribution. To clarify, Roth IRAs are individual accounts. You can still contribute to your employer sponsor plan. If you have a  401k, and it has a Roth option inside that account, or a 403b that has a Roth option inside there, you can still contribute, and I would recommend contributing money there. Again watch my  previous video to learn the differences between traditional 401k IRAs and tax-free Roth 401k and IRAs.

If we’re above these limits  we cannot contribute to the individual Roth IRA, but what we can do is open up a traditional IRA  instead of a Roth IRA.

We make a contribution to this account , this IRA account here, and we are not going to be able to take a tax deduction. This will be considered a non-deductible contribution to an  IRA.

Normally, if you make under certain income limits, and you put money inside an IRA, you get to reduce the amount of your taxable income  by the amount of the contribution you’ve made. That’s called a tax deduction for making a contribution to an IRA. There are no income limits to  opening and contributing to an IRA though. You just lose the ability to deduct that contribution, so this is the backdoor Roth. What we’re going to do here, we’re going to open up a  normal IRA. If you’re under the age of 50 in 2020 you can contribute as much as $6,000 into this. Again, no tax deduction.

Then  you immediately convert this IRA to a Roth, and now, your $6,000 non-deductible contribution that went into the IRA , you put it in there, no tax deduction, convert it to a Roth, and now your money is inside the Roth even if you have income above the limits that the IRA says  you cannot make more than in order to have contribution into a Roth IRA.

This is what’s the backdoor Roth is called. There is a very, very important  caveat here. It is called the pro-rata rule. Long story short, if you have a bunch of money already in  IRAs, this is probably not going to be a viable strategy for you. Let’s say you have an existing IRA account that has $500,000  in it.

What the IRA says is if we make a non-deductible contribution into an IRA, and then we  convert that to a Roth IRA. We have to calculate what the proportionate tax conversion is.  What that means is, if you put $5,000 into another IRA, non-deductible contribution, and then you want to convert that to  a Roth, you have to take into consideration this other huge IRA that you have, and they’re going to make you pay taxes on a portion  of that. You can’t just single out this $5,000 non-deductible contribution that you made into the IRA to convert to a Roth.  Normally, if you don’t have any other IRAs, this is 100% tax-free conversion because it’s a non-deductible contribution.

The pro-rata rule says if we have other IRA balances,  we have to take into consideration the amount in those accounts and when calculating the tax due for converting this to the Roth as we would in the normal backdoor strategy,  we have to pay taxes proportionate, a pro-rata amount of the existing IRA dollars. It only pertains to IRAs that you have . If you have 401ks or 403bs, those are employer sponsored plans, those are not included in the pro-rata rule, just any other IRAs.

One way to get around  this, you could consider rolling your IRA into the 401k at work so you no longer have an IRA, and then you’re eligible to do the backdoor Roth  contribution again. There are some workarounds here. If you make more money, then the IRS says you can in order to contribute to a Roth IRA. The backdoor may be  an option to consider, but be very, very careful of the pro-rata rule.

If you have other IRA dollars with big amounts inside there, it may not make sense for you to do it, and, of course,  talk to a financial professional, talk to a tax attorney, or CPA, if you’re considering doing something like this, and there’s some fogginess around your understanding of the rules.

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