High-income Earners, Maximize Your Savings with a Backdoor Roth IRA

Do you earn too much to invest in a Roth IRA? Do not fret, a backdoor Roth IRA can help you.

The Roth IRA is a significant tool for wealth building. It allows you to contribute money annually (in 2021, $6000) in an after-tax manner. But, the bonus is that all of the gains you make in the account through investments over the years can be withdrawn later in life completely free of tax. The contributions, the earnings, everything! For most people, contributing to a Roth IRA is as simple as going to a brokerage firm, such as Vanguard, Fidelity or E-trade, and depositing funds (up to the maximum IRS contribution). But for others, there is some maneuvering that has to be done to take advantage of this account.

A married couple making $208k per year or more, or an individual making $140k per year or more is not eligible to make a direct Roth IRA contribution in 2021 (note, the income brackets change every year).

BUT….

There is an indirect way to reap the benefits of a Roth IRA. It is commonly referred to as a backdoor Roth IRA. This can also be done for spouses who have no earned income up to the contribution limits imposed by the IRS.

Here are some straightforward steps to make the backdoor Roth a reality:

1. Do you currently have a balance in a traditional IRA and you’re not ready to pay any tax to convert the balance to a Roth? To avoid the pro-rata rule, which is basically a proportional tax you have to pay on conversions of money from a traditional to a Roth IRA, you’ll want to have all of your retirement funds sitting in 401k or 403b type accounts and a $0 balance in any traditional IRA accounts. Before you go to step 2, consider rolling any funds sitting in traditional IRAs over to a non-IRA retirement accounts to avoid pro-rata. This means you need to roll it over to an employer’s 401k, or if you have a small business, you should open a 401k and transfer it there. You will need an EIN.
2. Open a traditional IRA account. If you already have one open with a $0 balance, you can use that account. Note: Make sure steps 2-5 are done within the same tax year.
3. Make your contribution to the Traditional IRA ($6k maximum in 2021). Remember, this can be done for a spouse as well.
4. Open a Roth IRA. If you already have one opened, you can use that.
5. Once the balance shows up in the Traditional IRA, request a rollover of 100% of those funds to your Roth IRA. Typically you can do this online depending on which brokerage you choose. In certain states, conversions are subject to state income tax withholding. You can, however, opt out of this (since your contribution is already post-tax). You may need to submit an additional form or check a box to do this.
6. When tax time comes, you will be asked if you made “after tax” contributions to an IRA that year. You will indicate that you did. You will also be asked if you made any conversions of money that year. You will indicate you did.

Following these steps should ensure that you see a $0 tax liability (since you’re contributing the money after tax) and you’re able to successfully contribute annually to a Roth IRA regardless of income.

Good luck!