Around this time every year I get this question quite a few times from clients. It’s a good problem to have. Congratulations – your income is up! Bummer though, you may not be able to contribute to your Roth IRA anymore.
Au contraire. You may still be able to contribute to your Roth IRA through an indirect method: The Backdoor Roth IRA. We’ll get to that later. First, let’s take care of your “excess” contributions to avoid that pesky 6% penalty that is assessed for every year they remain in your Roth.
What are your options? Aside from keeping your excess contributions in your Roth IRA and paying that penalty each year (not ideal and probably not worth it), you have options to consider:
- Withdraw the excess contributions plus any applicable earnings. If you do this before you file your taxes, then you may be able to avoid that 6% penalty (the tax filing deadline for 2020 has been extended to May 17, 2021). The earnings will be taxed as income, however. Plus, if you are under the age of 59.5 then you may have to pay an additional 10% early withdrawal penalty on those earnings.
- File an amended return. If you have already filed your return, work with your accountant to file an amended return by the October extension deadline. This buys you time to make your withdrawal to avoid the 6% penalty.
- Apply the excess to next year’s contribution. If you think your income may decrease below the thresholds next year allowing you to contribute directly to the Roth, then you can pay the 6% penalty for this year and apply your excess contributions to next year.
- Move the excess contribution to a Traditional IRA through a recharacterization, including your earnings. Essentially, you are telling the IRS that these contributions were made into your IRA all along. Whether or not you are able to deduct these recharacterized contributions is up to several factors, including income and whether you or your spouse are covered by an employer-sponsored retirement plan.
Ok, so now you took care of your excess contribution for this past tax year. Good. But you like the idea of building up a bucket of money that you can use for retirement on a tax-free basis. So, what can you do now that you can’t make regular contributions to your Roth IRA?
You could make a non-deductible contribution to your Traditional IRA and then convert that contribution to your Roth IRA. If you recharacterized your previous Roth contribution to your IRA, you can convert these funds as well. This is the backdoor Roth IRA.
While there are income limits to consider when contributing to a Roth IRA, no such income limits exist for converting to a Roth IRA, making this strategy an attractive option.
This strategy works best when you do not already have pre-tax money in your IRA, like money from a 401(k) rollover for example, as any gains or pre-tax contributions converted are taxed at your income tax rates in the year of the conversion. The IRS also applies a pro-rata rule which does not allow you to only convert the non-deduction (or after-tax) amount – smart buggards – so in this case only a portion of your conversion is tax-free. You can possibly side-step this rule if your spouse does not have any pre-tax money in their IRA, as the pro-rata rule is applied on an individual basis regardless of tax filing status.
I tend to recommend to clients to spread out the different steps of the backdoor Roth IRA so the IRS will not put you on their “naughty list” thinking that you violated their contribution rules. I like to wait one statement cycle after the contribution is made before converting the funds. You will have documentation to show the money was put into the Traditional IRA first and then converted later as a separate transaction.
The backdoor Roth IRA strategy can be a great way to continue contributing and building up your Roth IRA, but it’s not for everyone. Let’s talk if you have any questions.
John Patrick Foley, CFP®, ChFC® and E3 Financial Planning are located at 175 Highland Ave, Suite 304, Needham, MA 02494. He can be reached at 781.444.4907 or firstname.lastname@example.org.
These materials are general in nature and do not address your specific situation. For your specific investment needs, please discuss your individual circumstances with your representative. Commonwealth does not provide tax or legal advice, and nothing in the accompanying pages should be construed as specific tax or legal advice. Securities and advisory services offered through Commonwealth Financial Network®, Member FINRA/SIPC. A Registered Investment Adviser.