As promised, here is the secret sauce for how you can contribute to a Roth IRA even if you are over the income limits by utilizing a completely legal loophole.
Many people hear about the tax advantages of Traditional and Roth IRA accounts but quickly dismiss their relevance because they believe they make too much money to use them. However, as we'll show you below, there is still a way to get all the benefits a Roth IRA has to offer (many of which are discussed in our post here) even if you are over the IRS income limits.
As discussed in our previous post, the IRS does not allow you to contribute to a Roth IRA if your income is over $131,000 if you are a single filer or over $193,000 if you are married filing jointly and the contribution limits begin to phase out at $116,000 and $183,000 for the two filing statuses, respectively. So if, as a couple, my wife and I were making $200,000 per year, how could we possibly be allowed to contribute to a Roth?
We call it "ghosting into a Roth." Others sometimes call it "the backdoor Roth." Whatever you want to call it, we believe this is one of the best hidden tax benefits available to high income earners.
How it Works:
You contribute money into a Traditional IRA without taking a tax deduction for your contributions (because you are over the deduction income limit, and therefore this money is going into your Traditional IRA after tax... which sounds a lot like a Roth IRA contribution doesn't it?). Then you convert that Traditional IRA into a Roth IRA.
Conversions into a Roth IRA usually result in out of pocket tax consequences. Key word: usually. The reason they usually result in tax consequences is because usually the money that is in a Traditional IRA was put in PRE-tax (meaning the individual/couple took a tax deduction for the contributions). Since you are converting the tax nature of the account from a pre-tax account to a post-tax account the IRS wants their fair share.
However, if the money contributed into your Traditional IRA was after-tax and there are no built-in capital gains in the account, then the principal has already been taxed and the IRS does not require a second taxation upon conversion to a Roth.
Now, the question we usually get at this point is: But I thought I wasn't allowed to contribute to a Traditional IRA because of how much money I make?
Therein lies the brunt of the confusion. You actually are allowed to contribute to your Traditional IRA regardless of your income, you just can't take a tax deduction for that contribution if you are over the limit. That is a big difference.
This means that you can contribute the annual limit of $5,500 (or $6,500 if you are over 50 years old) to a Traditional IRA regardless of what your income level is. But you will not be allowed to have that contribution reduce your taxable income when you go to file your tax return if you make too much money. (Just as a reminder, the Traditional IRA deduction income limts begin to phase out at income levels $61,000 if single and $98,000 if married filing jointly.)
Isn't this a huge administrative headache?
Yes. That is why you hire someone like us to take care of it for you. To accomplish this you usually have to open a new Traditional IRA account, a new Roth IRA account to convert into, and then you usually lose the Traditional IRA account each year when you convert it and therefore have to open a new Traditional account each year. If you are making a lot of money, this can seem like more headache than it's worth. But it adds up over time and it will likely more than cover the advisor fees you would pay to have a firm like ours take care of the administrative headache for you (plus you'd get all the other services we provide as a bonus).
How do I convert my Traditional IRA into a Roth?
It has to be completed through the custodian who houses your accounts. If you have an advisor, contact them and they will be able to take care of it for you. Also feel free to reach out to us for help.
What if I have other money in my Traditional IRA that went in pre-tax and has been invested?
Then your situation is more complicated and you need to be careful you don't trigger a tax consequence upon conversion. The easiest way to avoid this is to open a separate Traditional IRA account for your after-tax contributions and Roth conversion. Most custodians let you duplicate accounts already setup, so try to duplicate your Traditional IRA account and then contribute your after-tax dollars to this new Traditional acccount to segregate between pre-tax and after-tax money.
What if I make a bunch of money but have no idea what you're talking about?
Reach out to us here and tell us about your situation. We are happy to help and always do initial consultations for free where there are no commitments on your end before you have the opportunity to decide whether the value add we provide is worth it to you.
Disclosure: Do not rely on this post as investment or tax advice. Please consult your investment and tax advisors before pursuing any of the strategies discussed in this post. Do your own homework for your individual situation.