Roth IRAs are a great way to save for retirement. They grow tax-free, have no required minimum distributions and the principal is available before age 59 ½ if you need it. So, why doesn’t everyone contribute to a Roth IRA?
One reason is that the IRS doesn’t allow Roth IRA contributions for taxpayers whose income exceeds certain threshold amounts. If you are single and have an adjusted gross income (AGI) over $131,000, you may not contribute to a Roth IRA in 2015. If you are married and your AGI exceeds $193,000, you have the same problem.
For a complete breakdown of the IRA contributions you can make based on your income, visit the IRS website by clicking here.
However, there is a workaround. In 2010, Congress passed legislation that allows anyone to convert a traditional IRA to a Roth IRA regardless of income.
In through the backdoor. Known as a “backdoor” Roth IRA, high-income earners who make more than the threshold amounts can open a traditional IRA and immediately convert it to a Roth. Any interest or gains would be taxable, but if you convert right away, there won’t be any taxable gains or interest to worry about. Instantly a traditional IRA becomes a Roth IRA. You can repeat this process every year that you have earned income that exceeds the threshold amounts.
But there is a catch. There is one little detail that derails a lot of people. Roth IRA conversions are subject to the pro rata rule. The pro rata rule means that if you convert an IRA to a Roth, the tax-free portion of the conversion is equal to the percentage of your total IRA holdings that consist of after-tax dollars.
For example: You have an existing traditional IRA worth $95,000. This IRA was funded with pre-tax money from a 401(k) rollover. You also have a $5,000 IRA funded with after-tax dollars that you want to convert to a Roth IRA. In the eyes of the IRS, IRAs are aggregated and considered to be one big IRA even if they are held in separate accounts as these two are. When you convert the $5,000 after tax IRA to a Roth, the IRS says that only 5% of $5,000 conversion is tax-free. The other 95% is considered taxable since 95% of your aggregated IRA balance is pre-tax money – in this case from a rollover.
Does that make sense? If not, check out this post from IRA guru, Jeff Levine, detailing the pro rata rule.
Where this strategy fits. The pro rata rule prevents many people from implementing the backdoor Roth IRA strategy since they already own pre-tax IRAs. However, the backdoor strategy can be a fit in the right situation. If you have an adjusted gross income that exceeds the amount shown above AND you do not own a pre-tax IRA outside your retirement plans at work, then the backdoor Roth IRA conversion strategy may work for you.