There is a common piece of financial advice given to people like me which I strongly disagree with1Full disclaimer: If you haven’t read the linked post, you should probably do so before reading this one. . By people like me I mean people who are currently making a low income but are “expected” to make a higher income in the future. And the advice is this: contribute to a Roth IRA instead of a Traditional IRA while your income is low. I’ve already discussed in detail why this is bad advice in general. But one of the main (legitimate) pushbacks I get when promoting Traditional IRAs is that you ultimately want to have your savings in a variety of account types, so that in retirement you can optimize withdrawals from Traditional accounts (which are tax free up to the standard deduction amount) with withdrawals from other accounts like the Roth IRA. I agree with the general philosophy–you don’t want ALL your savings in Traditional accounts. But as it turns out, there are MASSIVE opportunities for Roth IRA contributions for high income earners. And that’s what we’re talking about today.
The backdoor Roth IRA
Above certain income limits, as shown in the chart below, you cannot contribute to a Roth IRA. There are also limits for a Traditional IRA, but these are limits for tax deductibility, not contributions. In English, you can contribute to a Traditional IRA but you can’t deduct the contribution from your income. Also, you may notice ranges in the table below. For Roth IRAs, if your income is in the range you can contribute somewhere between $0 and $5,500. For Traditional, only part of your contribution is tax deductible.
Ok, so let’s talk about what we know. Traditional (tax deductible) > Roth > neither. So if we’re above the income for tax deductibility for Traditional we should contribute to a Roth. And what if we’re above the Roth income limit? Then it’s time for the Backdoor Roth.
Here’s how it works, step by step:
- At the beginning, your Traditional IRA balance has to be $0. If it’s not $0, see if you can roll it over into your 401k at work. If you can’t, apparently you can just open an Individual 401k that allows rollovers2Double check before you open it! Vanguard doesn’t allow rollovers. .
- Make an after tax contribution to a Traditional IRA. And do this in one big lump sum. I know you can afford a one time investment of $5,500 because you’re filthy rich if you’re doing this!
- Immediately convert the money in your Traditional IRA to your Roth IRA. The conversion is a taxable event. That means if the money in your Traditional IRA was tax deductible when you contributed it, you’ll have to pay income tax on the conversion. Hence step number 1. If the money you contributed was post-tax, and you haven’t made money on that money (hence “immediately” at the beginning of number 3), then you’ve already paid tax and you won’t owe anything on the conversion.
- When you file your taxes, you’ll have to fill out form 8606. There are instructions.
- After 5 years, that money counts as principle and you can withdraw it without penalty.
Not a bad system. The point is this: if your income is above the Roth IRA limit, you can still contribute to a Roth IRA. Lucky you.
But it gets even better. And part of the reason it gets better is because we’ve now come to a point in the blog where I get to use my favorite term in personal finance:
THE MEGA-BACKDOOR ROTH IRA!!!!
Man that felt good. I won’t spend too much time on this, because the concept is the same as the above. We’ve talked about 401ks before. The contribution limit is $18,500. Your employer can match a portion or all of this. After that, you can also make after tax contributions to your 401k, such that the sum of $18,500 and your employer matching and your after tax contributions remains less than or equal to $55,000 per year. For example, if you max out your 401k and your employer contributes an additional $6,500 you’ll be at $25,000 (18.5k + 6.5k = 25k). Since 55k – 25k = 30k, you can make up to 30k in after tax contributions. Note that not all 401k plans will allow this. Or the next step.
IF your 401k plans allows “in service distributions”, you can then roll over the after tax portion of your 401k contributions to a Roth IRA. This would allow you to contribute tens of thousands of dollars per year into a Roth IRA (ironically, several times the normal contribution limit) even when you’re above the income limit.
Sorry if this one was a bit dry, but it has serious implications for high income earners who don’t want to be a slave to taxes forever. If you’re not quite there yet, this is the key takeaway for you: There are massive opportunities to contribute to a Roth IRA down the road. So stick with Traditional and enjoy the extra money you would’ve paid in taxes! And by enjoy I mean save and invest it :).