Written by: Corey Janoff
We’re in the beginning of tax season and there is still time to contribute to an IRA for last year! Whether it's a Traditional IRA, Roth IRA, or Backdoor Roth IRA, the IRS allows you to make prior-year IRA contributions up until the tax filing deadline of April 15th. We have a 15 ½ month window to make IRA contributions every year (you can make 2020 contributions from January 1, 2020, to April 15, 2021. 2020 was an exception with the tax deadline extended to July).
If you haven’t done so already and you are eligible to contribute (more on this in a moment), get your contributions done before the deadline!
Some of you are probably aware that there are income restrictions on being eligible to contribute directly to a Roth IRA. Even better, some of you are probably over those income limits. If you are one of the fortunate individuals or households who earn too much money to contribute to a Roth IRA, please don’t complain to your friends who are eligible. They won’t like you.
If you do earn too much money to contribute to a Roth IRA, there are still ways to get money into a Roth IRA. That is what we will discuss here today. If you are unfamiliar with how a Roth account works, please read this post about the differences between Roth and Pre-Tax retirement accounts. People like Roth accounts because you can withdraw the money from the account tax-free in retirement. The more tax-free money, the better.
What Are the Income Limits for Roth IRA Contributions?
Every year, the IRS will revise the income limits on Roth IRA eligibility, usually to adjust for inflation. For 2020 contributions, if you are single and earned over $139,000 of modified adjusted gross income (MAGI) in 2020, you cannot contribute anything to a Roth IRA. For most of you, MAGI is your gross income minus what you contribute pre-tax to a retirement account at work. If you earned under $124,000 as a single individual, you are allowed to contribute the full $6,000 to a Roth IRA ($7,000 if age 50 or over). If you earn between $124-139k you can contribute a pro-rated amount.
As a married couple filing jointly, if your combined household income (MAGI) was above $206,000 in 2020, you cannot contribute to a Roth IRA. Below $196,000, you and your spouse can each contribute $6,000 ($7,000 if age 50+). In between $196-206k is a pro-rated amount.
If you are married and file taxes separately, you cannot contribute to a Roth IRA, period! Well, if you earn under $10,000, you could make a partial contribution, but I don’t think you are doing much retirement savings at that income level. It’s really important that if you file taxes separately you are aware of this.
These income restrictions only apply to Roth IRA accounts. You can make Roth contributions to employer-sponsored retirement plans, such as a 401k or 403b, regardless of income. Don't ask me why. I don't make the rules. Talk to Congress.
Once you earn too much money to contribute to a Roth IRA, the money you already contribute will remain invested in the account. You just cannot add more money to the account in the years you earn too much. It’s evaluated on a year-by-year basis. Those of you who are close to the income cutoff might have some years in which you are eligible and other years in which you are not (due to a bonus or something).
If you would like to add more money to your Roth IRA despite being over the income limit for eligibility, this is where the Roth conversion strategy, aka the Backdoor Roth IRA, comes in.
How to Do a Backdoor Roth IRA Contribution
It is great that this perfectly legal loophole exists because it enables higher-income earners to still get money into a Roth IRA that can be accessed tax-free in retirement. Before 2010, this wasn’t an option, but in 2010 a provision in the tax code went away, opening up the back door to the Roth IRA.
The backdoor Roth IRA is really quite simple, but easy to mess up, so follow closely.
Step 1: Make sure you have a clean work surface. Pretend like you are baking a cake and following a recipe. The first step is to have a clean work surface, so no debris inadvertently gets in your batter.
What I mean by having a clear work area is you cannot have any other IRA accounts with a balance in them. If you have an existing Traditional IRA, SIMPLE IRA, or SEP-IRA, stop immediately. Do not pass go. Do not collect $200.
Without going too far into the weeds here, if you have an existing pre-tax balance in an IRA account and do a Backdoor Roth IRA, you will run into a tax nightmare called the pro-rata rule and basically end up paying taxes twice on your money. No Bueno.
In order to avoid this problem, you have several choices.
- Don’t contribute to a backdoor Roth IRA. This is the easiest option, but stunts the accumulation potential in your Roth money, therefore reducing the amount of tax-free money available to you in retirement.
- Roll all of your pre-tax IRA money into a qualified retirement plan, such as a 401k or 403b, so you no longer have any IRA balances. This only is an option if you have a 401k/403b type account and it accepts rollover contributions from IRA’s (most do).
- Convert your pre-tax IRA accounts into your Roth IRA. If you do this, the amount converted will need to be claimed as income and you will owe income taxes on that full amount (due in April the following year). If you have a relatively small balance and can afford the taxes owed, this could be worthwhile.
Bottom line, if you’re going to do a Backdoor Roth IRA, you cannot have any other IRA accounts with balances in them.
Step 2: Open a Traditional IRA and contribute money into it (up to $6,000, or $7,000 if age 50+). It is easiest if you contribute the full amount all at once, rather than spread out over time.
IRA stands for Individual Retirement Account, so only one individual can own the account. Therefore, if married, each spouse will need to open their own account. If only one spouse earns income, the income-earning spouse can contribute to the non-income earning spouse’s account.
Step 3: After funding the Traditional IRA, convert the balance of the Traditional IRA into your Roth IRA. This can usually be done online, or by signing a form, depending on the company your accounts are held at. If you don’t already have a Roth IRA, open one up and then convert the Traditional IRA into it.
You should convert from the Traditional IRA into the Roth IRA as soon as possible. Usually, you will have to wait a few business days for the money to settle in the account before it can be converted (the investment company needs to make sure the bank clears the deposit before moving the money elsewhere).
If you invest the money in the Traditional IRA before converting it into the Roth IRA, you will be required to pay income taxes on any investment gains, hence why it is best to convert it into the Roth IRA as soon as possible.
Step 4: Once the money is in the Roth IRA, get the money invested. The last thing you want to do is leave your new contribution in cash, as it will have no chance of growing over time.
Step 5 (Most Important): When you file your taxes, be sure to let your accountant know you made a nondeductible IRA contribution and then subsequently converted the non-deductible IRA into a Roth IRA. Non-deductible means you are not taking a tax deduction on the contribution. It is money you already paid income taxes on. This way, you don’t have to pay any taxes on that same amount when it is converted into the Roth IRA.
It's also important to correctly report the year for which the contribution is going in. If you are making a prior year contribution for 2020 before the tax deadline (even though it is 2021 now), you must report the contribution as a 2020 contribution with the investment company and on your tax return.
If you have done your own taxes up to this point, I recommend working with an accountant instead of moving forward. If you are insistent on continuing to do your own taxes, make sure you document this correctly when filing taxes. Good luck to you.
The IRS Form 8606 for Non-Deductible IRA’s
An IRS form 8606 will be generated and filed with your tax return to inform the IRS that you didn’t take a tax deduction on your contribution to the Traditional IRA. If that form isn’t on file with your tax return, the IRS assumes the money in your Traditional IRA is pre-tax money that you didn’t pay taxes on yet (because normally that is the case with Traditional IRA’s). Again, super important that you report your IRA contribution as a non-deductible IRA contribution, and the IRS form 8606 that documents non-deductible IRA's is filed with your tax return for that year.
When you convert your Traditional IRA into your Roth IRA, the investment company your account is held at will populate a 1099-R statement for the year the conversion occurred in. The 1099-R statement shows that money came out of a retirement account – in this case, a Traditional IRA. Normally, you have to pay income taxes on all money being converted from a pre-tax retirement account into a Roth IRA.
If the non-deductible contribution wasn’t documented correctly and the Form 8606 isn’t filed, the IRS assumes you converted pre-tax money into a Roth IRA, which is a taxable event.
This will cause one of two things to happen. Either the tax software will assume it was pre-tax money that was converted into the Roth IRA and you will end up erroneously paying income taxes on the amount converted, even though you already paid taxes on that money. So you end up paying double taxes. Be sure to double-check your tax return before filing. If the form 8606 isn’t in there, it wasn’t done correctly.
Or, if you forgot to report the contribution altogether, you won’t pay income taxes on the money being converted, because you know you already paid income taxes on that money. However, the IRS will get wind of this conversion when the 1099-R is generated and will incorrectly assume that you should have paid taxes on that money being converted. In this case, the IRS will be very, very angry with you. About a year later (because the government is slow), you will get an angry letter from the IRS informing you of how angry they are. They will also demand you pay income taxes, plus a penalty, on that money that was converted into your Roth IRA.
Not fun to be on the wrong side of the IRS. If this does happen, you can remedy the situation by writing a letter explaining what happened and amending your tax return to properly document the non-deductible contribution with the form 8606. This can be a pain in the tuchus, and it will cost you money to amend your tax return, so try to document everything correctly the first time around.
It’s best if you contribute to the non-deductible IRA before the end of the year and convert the IRA into the Roth IRA before December 31st in the same year. That makes filing taxes cleaner because you can match the form 8606 with the 1099-R for the same year. If you make your 2020 non-deductible IRA contribution now (in 2021) and also convert the IRA into your Roth IRA in 2021, you will have the Backdoor Roth IRA documented over two tax years. You will have a non-deductible contribution reported on form 8606 for your 2020 tax return and a 1099-R documenting the conversion into the Roth IRA on your 2021 tax return. This is perfectly acceptable but makes things slightly more challenging to track and report. Hence why if you can do it all in the same tax year before December 31st, things will be cleaner from a tax filing perspective.
Roth IRA’s are great because you can withdraw from them tax-free in retirement. The Backdoor Roth IRA is a unique strategy that enables high-income earners to potentially add new money to a Roth IRA each year.
There are some important rules to follow if you are going to pursue the Backdoor Roth IRA strategy. They are straightforward, yet easy to miss if you’re not attentive.
Step 1 – clear your work surface. Make sure no money is in a Traditional/SEP/SIMPLE IRA with your name on it.
Step 2 – add money to a Traditional IRA.
Step 3 – convert Traditional IRA into Roth IRA.
Step 4 – invest the money in the Roth IRA.
Step 5 – report that you made a nondeductible IRA contribution and ensure that an IRS form 8606 is filed with your tax return.
This post should not be construed as tax advice. Please consult with a tax professional for advice on your particular tax circumstances before proceeding. Qualified withdrawals from Roth IRA’s can be made tax-free if the account owner is over the age of 59 ½ and has held the account for at least five years. Investments involve the risk of loss, including total loss of principal. Consult with your financial advisor before making any investment decisions.