By Sarah Brenner, JD
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You may be interested in contributing to a Roth IRA but think your income is too high. You are probably aware that there are income limits that apply to Roth IRA contributions. For 2018, if you are married, your ability to make Roth IRA contributions phases out when your Modified Adjusted Gross Income (MAGI) is between $189,000 - $199,000 and between $120,000 - $ 135,000 if you are single. Are you out of luck if you are a high earner? The answer is "no" and tax reform makes this clearer than ever.
How the Back-Door Roth IRA Works
You can easily bypass the Roth IRA contribution income limits, by doing a back-door Roth IRA conversion.
Here's how it works…
You make a nondeductible traditional IRA contribution for 2018. You can contribute up to $5,500 ($6,500 if you are 50 or over). Your high income will not be a problem, because there are no income limits on nondeductible traditional IRA contributions. Your next step is to convert your 2018 traditional IRA contribution to a Roth IRA. You now have your money in your Roth IRA where it can begin to grow tax free.
Cautions When Using this Strategy
Sounds good, right? Well, there are a couple of cautions. You must have earned income, such as wages or self-employment income, to make the initial traditional IRA contribution. Also, you must be under age 70½ in 2018. This is because traditional IRA contributions cannot be made in a year that you are 70½ or older.
If you have other traditional IRAs, you will also have to watch out for the pro-rata formula. This is because all your traditional IRAs, including any SEP and SIMPLE IRAs, are included in the pro-rata calculation that is done to determine the taxation of your conversion. This can result in your nondeductible traditional IRA contribution ending up being taxed when you convert it.
Another important consideration is that the funds that end up in the Roth IRA through a back-door conversion are converted funds, not Roth IRA contributions. This makes a difference if you are under age 59½. You must then wait 5 years for penalty-free access to those funds. If you had been eligible to make Roth IRA contributions, those contributions would have been accessible to you immediately, tax and penalty-free.
Tax Reform Brings Good News for Back-Door Roth IRA Conversions
In the past, there have been concerns about the legality of back-door Roth IRA conversions. To some, this strategy seemed too good to be true and an attempt to exploit a loophole. These transactions have been consistently dogged by rumors that Congress or the IRS was ready to shut them down.
The Tax Cuts and Jobs Act appears to put these fears to rest by confirming that the back-door Roth is an allowable strategy. This is because there are several references to the back-door Roth strategy included in Congress' Conference Committee report that accompanies the new law.
Right for You?
Is this the year that you take advantage of the back-door Roth IRA strategy? Is it right for you? Tax reform means that any conversion done in 2018, including a back-door Roth IRA conversion, is irrevocable. You will need to be sure that it is a good move for you. To learn more, your best bet is to discuss your specific situation with knowledgeable tax or financial advisor.