High-income individuals and their spouses aren't permitted to contribute money directly to a Roth IRA. But there's a way around the Roth income limits for people who'd like to avoid taxation in retirement, known as the backdoor method. Here's a rundown of why this may be necessary, and how the process works.
The 2017 Roth IRA income limits
With a traditional IRA, your ability to deduct your contributions is limited only by your income if you or your spouse are eligible to participate in a retirement plan at work. And even if this is the case, you can still make nondeductible contributions that can grow tax-deferred.
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On the other hand, all investors are subject to the Roth IRA income limits. For 2017, the adjusted gross income (AGI) limits are:
|
Tax Filing Status |
2017 Tax Year |
|---|---|
|
Single or head of household |
$118,000-$133,000 |
|
Married filing jointly |
$186,000-$196,000 |
|
Married filing separately |
$0-$10,000 |
Data source: IRS.
If your AGI is below the lower limit for your tax filing status, you can make a full contribution to a Roth IRA, up to the annual limit of $5,500 for 2017 ($6,500 if you're 50 or older). If your AGI is in the middle of the range, you can make a partial Roth IRA contribution. And finally, if your income is above the higher limit for your filing status, you can't contribute directly to a Roth IRA at all for 2017.
The backdoor Roth IRA contribution method
While the income limits might prevent you from contributing money directly to a Roth IRA, you can still use the "backdoor method" to put your money into a Roth.
In a nutshell, the rules say that anyone can contribute to a traditional IRA and then convert the account to a Roth IRA, no matter how much money the person makes. So the backdoor method consists of contributing to a traditional IRA and converting the account to a Roth shortly after.
Typically, taxes are a big concern when converting, since you'll have to pay income tax on any of your converted funds for which you received a traditional IRA deduction. However, if you complete the conversion before the end of the tax year in which the contribution was made, this won't be an issue -- which is why I said to convert "shortly after" making the contribution.
As far as the paperwork aspect goes, converting a traditional IRA to a Roth IRA is usually a fairly painless process. First, open a Roth IRA with the brokerage of your choice. Then, request and fill out an IRA rollover form, which will authorize the transfer of the traditional IRA's assets to your Roth IRA. It's that easy.
Why contribute to a backdoor Roth IRA instead of a traditional IRA?
The most obvious advantage of a Roth IRA is the tax benefit. Contributions to a Roth IRA are tax-deductible, but qualified withdrawals in retirement will be 100% tax-free. This can be especially useful if you have other retirement savings in tax-deferred accounts, such as a 401(k), as it provides an additional element of diversification.
In addition, Roth IRA contributions (but not investment profits) can be withdrawn at any time, for any reason, without penalty. Roth IRAs also have no minimum distribution requirements and can be excellent tools for estate planning.
In a nutshell, Roth IRAs have some excellent benefits, so while you weigh the pros and cons of both main types of IRA, keep in mind that the Roth option can be available to you, regardless of how much money you make.
