How to Open a Roth IRA Even If You Don't Qualify!
A short time ago I wrote about the Roth IRA. It's a really sweet deal in which you save after tax income today and the money grows and is withdrawn tax-free at retirement! In 2018, you can contribute up to $5,500 ($6,500 if you’re 50 or older) per year. As an added benefit, because there is no age at which you must make withdrawals, you can use the Roth as an estate-planning tool to leave tax free money for your heirs. The only stipulations are that you don't make withdrawals until you are 59½ and that you do not withdraw a deposit for at least 5 years. The problem of course, is that the Roth IRA is unavailable to individuals making more than $134,999 ($198,999 for couples). Those making between $120,00 to $134,999 ($189,000 to $198,999 for couples) can participate at a reduced amount. Please see our friends at the IRS for specific details. For many of us starting out in our careers, those might seem generous; however, established individuals can quickly bump into these limits. Fortunately, there is a work around.
In 2010 congress passed legislation that introduced additional flexibility to Roth IRA accounts. Although perhaps not the original intention, this created a loophole often referred to as the “Backdoor Roth.” It's a three-step process. First, you open a traditional IRA and make a contribution with after tax monies. Second, you open a Roth IRA (or use an existing one) and transfer the money into the Roth. Third, file an IRS Form 8606, which will account for both the addition of non-deductible funds to an IRA and the conversion to a Roth– don't forget this step! To minimize complications, all three steps should be completed in the same year. During the time between the opening of the traditional IRA and the conversion, some appreciation may have occurred. You will need to pay taxes on this and you will report this on the 8606.
This sounds all simple – and it is, unless you have any pre-tax IRAs in your portfolio. This includes any rollover IRAs from previous employers’ 401K. Why? Because of something called the IRA aggregation rule, which states that when an individual has multiple IRAs, they are all treated as one account when determining the tax consequences of any distribution. Because of this, when an individual has multiple IRAs – some with pre tax and others with post tax monies - the IRS considers any distribution to be composed of a combination of the two on a pro-rata basis.
If you have a mix of pre and post-tax IRAs and want to try the “back door Roth”, you essentially have two options. The simplest might be to take the pre-tax IRA accounts and roll them into your current employer’s 401K. Once rolled back into a 401K the pre-tax IRA I is no longer affected by the aggregation rule. Many employers will allow this; however, it may not be the best option depending on your 401K plan. The alternative is to follow the IRS’ pro-rata rule. Essentially the rule determines how much of a distribution is taxable based on the value of the pre and pre-tax dollar IRAs. For example, if you have a rollover IRA worth $100,000 from a previous 401K (pre tax) and you open a traditional IRA and deposit $5,000 of after tax money. To determine the amount of the IRA conversion that would be tax free, take the after-tax IRA ($5,000) and divide by the total value of all IRAs you hold ($105,000). So ~ 4.8% - $238 - of the $5,000 would convert to the Roth IRA tax-free. You would be responsible for paying income tax on the ~ $4,762. Is it worth paying tax on $4,762 to enjoy the tax-free appreciation of a Roth account? Maybe - maybe not. If you hold IRAs with pre-tax monies you’ll have to do the math and see.
One last note; you will read about the need to wait an unspecified period of time between open the traditional IRA and the conversion step. This was to avoid violating something called the “step-transaction rule”. The new tax law has eliminated this concern so now there is no need to wait.