Contributing to a Roth IRA When You're Over the Income Limit

by Michael on Jan 16, 2013 · 2 comments

Photo of a Golden Nest Egg

Earlier this week, I talked about advantages of the Roth IRA. But I also pointed out that Roth contributions are subject to an income limit.

So what can you do if you’re over the limit? Simple. Go ahead and fund your Roth IRA through the so-called “backdoor.”

This is a fairly common strategy wherein you contribute to a traditional IRA and then convert those funds into a Roth IRA.

While there are limits on deductibility of your IRA contributions, there are no such limits for funding a traditional IRA. Can’t deduct your contribution? No problem. Just make a non-deductible contribution.

Yes, there used to be income limits for doing a Roth conversion, but those went away back in 2010, so you’re now in the clear to pull this off.

Contribute to traditional IRA --> Convert to Roth IRA --> Done.

Pretty slick, huh?

While the mechanics of this are straightforward, I do need to warn you about a few possible complications…

For starters, the IRS treats all of your IRAs of a certain type as a single bucket of money. Thus, if you have an IRA with deductible contributions, you won’t be able to make non-deductible contributions and convert just that money to a Roth IRA.

Instead, your funds will be pooled and you will be taxed on your conversion based on the ratio of deductible:non-deductible funds. You can still use the backdoor approach, but it won’t be as simple or straightforward.

The cleanest way to handle this situation would be to first roll the deductible contributions (and subsequent earnings) from your traditional IRA into a 401(k) or 403(b). This excludes them from the pro rata tax calculation and clears the way for backdoor contributions without complications.

The other big consideration is legal. While none of the steps outlined above run afoul of IRS regulations, Michael Kitces has wondered aloud whether or not this contribute-and-convert maneuver runs afoul of the step transaction doctrine.

For those that are unaware, the step transaction doctrine allows the IRS to look at the overall outcome of a multi-step transaction and tax it based on that. Thus, the IRS could conceivably look at the backdoor Roth and decide that you have effectively over-contributed to your Roth and penalize accordingly so.

Keeping in mind that the penalty for over-contributions is rather nasty — 6%/year until the money is removed (but with a three year statute of limitations) — this is definitely something to keep in mind. However, others have weighed in to argue that the step transaction doctrine isn’t really a concern here.

In this regard, the most common advice I’ve seen has been to allow a bit of time (how much? that’s not entirely clear) to pass between the original contribution and the conversion. As for me, I’ve already completed step 1 (the contribution) and will do the conversion within the next month or two.

1 Chuck January 18, 2013 at 8:25 pm

If I want to do the “Contribute to traditional IRA –> Convert to Roth IRA,” can I set up a new Traditional IRA account (e.g., in Vangaurd) that is separate from my other, existing IRA in Morgan Stanley, and then only convert that the new Traditional IRA to a Roth IRA (which is in Vangaurd) and not worry about IRS “pooled issues”? Thank you.

2 Michael January 18, 2013 at 10:25 pm

Chuck: Unfortunately, the IRS views all of your traditional IRAs as a single pot of money even if they’re held at different places. So the short answer is “no,” you can’t work around the pro rata (pooling) issues by opening a new traditional IRA at Vanguard.

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