IRA Contributions for High Income Earners

Two weeks ago, we discussed in depth that the ability to make traditional deductible individual retirement account (IRA) contributions phases out for those covered by a retirement plan at work when adjusted gross income (AGI) exceeds $75,000 for single filers or $124,000 for married couples in 2020. Similarly, ROTH IRA contributions in 2020 are fully disallowed when AGI exceeds $139,000 or in the case of married couples, $206,000. These phase outs leave only one IRA contribution option for those who are covered by a workplace retirement plan with AGI in excess of the above numbers – the after tax (non-deductible) IRA contribution. As a reminder the after tax (non-deductible) IRA contribution is the least desirable of all IRA contributions because there is no up-front tax deduction for the contribution but all the earnings and growth on the contribution is still taxable upon withdrawal from the account in retirement.

Instead of settling for the smaller tax benefits of the after tax (non-deductible) IRA contribution or simply abandoning the idea of utilizing IRAs altogether, consider the use of a what is referred to as the “back-door” ROTH strategy.

The “Back-Door” ROTH Mechanics

A “back-door” ROTH IRA is not actually a separate type of IRA but is a multi-step strategy for high income earners to be able to contribute indirectly to a ROTH IRA. High income earners cannot walk directly through the front door into the ROTH house. Instead, the only door available to them is the back door and getting in the back door requires two steps: going through the side gate and then going through the back door of the ROTH house.

Step one (going through the side gate) is to make a non-deductible traditional IRA contribution. Step two (entering through the back door) is converting that non-deductible traditional IRA into a ROTH IRA. The term conversion is a technical term that can be a tripping point so we will discuss this more later on.

This strategy is possible because any taxpayer with earned income (regardless of age or AGI) can make an after tax (non-deductible) IRA contribution (enter the side gate). Coupled with this ability, ROTH conversions (the back door) have been available to all taxpayers regardless of income level since 2010. A ROTH conversion allows a taxpayer to move dollars from a traditional IRA to a ROTH IRA at any time.

Dr. Joe is a young physician who has just paid off his medical school debt, is maxing out his HSA and 401(k) contributions, and is looking for additional vehicles to help him lower his lifetime income taxes. Dr. Joe’s AGI is $350,000 barring him from making a deductible traditional IRA or direct ROTH IRA contribution. Being the intelligent doctor that he is, Joe sets up a traditional IRA and maxes out his annual $6,000 contribution even though it will not be deductible. Some time later, Dr. Joe converts his traditional IRA to a ROTH IRA moving his $6,000 plus any earnings to a ROTH IRA.

The Benefits of “Back-Door” ROTHs

For those with the ability to save in addition to their health savings account (HSA) and employer retirement plan such as a 401(k) or 403(b) the location of those additional savings is important. The compounded benefits of the ROTH IRA over a brokerage account or even the after tax (non-deductible) IRA contributions are difficult to overstate.

The graph below depicts a married couple that fully funds both spouses IRAs every year from age 30 until age 70. The couple is deciding whether to take the extra step and convert they non-deductible traditional IRA contributions into “back-door” ROTH IRA contributions. The graph below shows the projected after-tax value of the account at various ages assuming a 5% before tax rate of return and a 24% tax rate. In the end, the two ROTH IRAs are worth $257,164 more to the couple than the two non-deductible IRAs at age 70!

Taxation of a ROTH Conversion

ROTH conversions take dollars from traditional IRAs to ROTH IRAs and therefore are taxable events. Any dollars that have yet to be taxed that are moved from a traditional IRA to a ROTH IRA result in taxable income. For example, if Dr. Joe’s traditional IRA had grown to $6,005 before he made the ROTH conversion of the full balance, the conversion would create $5 of taxable income. The $6,000 is not taxable because no deduction was ever taken, however, the $5 of growth has not been taxed and any untaxed dollars entering a ROTH create taxable income.

The Limitations of “Back-Door” ROTHs

This characteristic of ROTH conversion taxation leads us to the limitations of this strategy. The IRS considers any conversion from a traditional IRA to a ROTH IRA to be proportional after aggregating all traditional, SEP, and SIMPLE IRAs. This requirement to aggregate and prorate can easily trip people up as they attempt to fund the ROTH via the back door.

Dr. Will overheard Dr. Joe talking about his “back-door” ROTH IRA around the operating table and so he contributed $6,000 to his IRA which was not deductible since his income exceeded the threshold. Dr. Will then converted the $6,000 to a ROTH IRA. However, when it came time to prepare Dr. Will’s tax return, his CPA informed him that because Dr. Will changed jobs a few years ago and rolled his old 403(b) into a traditional IRA and that traditional IRA had a market value of $100,000 at the end of the previous year 94% of the $6,000 conversion is taxable. The CPA explains that Dr. Will has a traditional IRA with $6,000 of non-deductible contributions and $94,000 of pre-tax contributions and growth and therefore the proration rule only allows 6% of the $6,000 conversion ($360) to be attributed to the non-deductible contribution resulting in 94% ($5,640) being taxable.

The existence of pre-tax IRAs like in Dr. Will’s case deny the “back-door” ROTH strategy of any benefit. Dr. Will might be able to still salvage this strategy by asking his current employer if he can roll his $94,000 of pre-tax IRA into his workplace 401(k) or 403(b) plan. Some plans allow for this, but some do not, so it just depends on the plan. Alternatively, if Dr. Will has any self-employment income he can set up a solo 401(k) and roll the $94,000 into the solo 401(k). Since employer plans such as 401(k)s and 403(b)s do not have to be aggregated when calculating the proration rule this would result in Dr. Will only having $6,000 of market value in his IRAs and all $6,000 is after tax. Upon conversion to the ROTH, none of the $6,000 is taxable because it is all after tax.

One additional note, the proration rule is calculated on Form 8606 that is filed with your tax return. This requires you to aggregate all IRAs in your name. Neither your spouse’s IRAs nor any inherited IRAs have to be aggregated.

Step Transaction Doctrine

The ROTH IRA is one of my favorite vehicles because of the flexibility it offers and the ability for high income earners to benefit from its attributes. That being said, I will leave you with a word of caution. The Internal Revenue Code has a provision referred to as the step transaction doctrine. This doctrine says that if you perform multiple allowable steps that in total amount to one disallowed step, then the series transactions is disallowed.

Over the years there has been concern that the “back-door” IRA would be considered a step transaction since high income earners are not allowed to make ROTH IRA contributions directly through the front door but instead use the ROTH conversion feature to essentially make the ROTH IRA contributions through the back door. Congress danced around addressing the “back-door” ROTH in a recent Conference Committee Report at the end of 2017 and on pages 23 and 24 clearly states that the two steps themselves, making a traditional IRA contribution and converting a traditional IRA to a ROTH IRA are allowed. However, not all of the advisor and CPA communities are convinced the step doctrine will not rear its head so take care to give it consideration when looking at this strategy and consider allowing the traditional IRA contributions to sit for a period of time before actually converting them into a ROTH IRA.

The ROTH IRA is a great vehicle and I encourage you to seek out your advisor to see if there is a way for you to enhance your financial future with its tax friendly features.