3 Options for High Income Earners to Fund Roth IRAs

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High income earners are fortunate to potentially have enough income to save well for retirement. But if their income is too high, they won’t be eligible for annual contributions to Roth IRAs. They need not, however, rule out Roth IRAs in their retirement income planning strategies because they can use other methods to fund Roth IRAs—retirement plan rollovers, IRA conversions, and the backdoor Roth.

There are varying tax effects with these alternative funding methods that savers should be aware of before they make decisions. And two of these three options cannot be undone as a result of recently enacted legislation that eliminated the opportunity to recharacterize retirement plan rollovers and conversions. While savers may ask their IRA administrators questions about funding Roth IRAs, they should discuss these retirement saving strategies with competent tax or financial advisors.

Roth IRAs

Roth IRAs are appealing because they can provide tax-free earnings in retirement. All contributions to Roth IRAs are made on an after-tax basis. The generated income grows tax-deferred and is tax-free when distributed if the Roth IRA owner meets qualified distribution requirements (a five-year holding period, and is age 59½ or older, disabled, a beneficiary, or meets first-time homebuyer requirements).

An individual's contributions to all of their Traditional and Roth IRAs are limited to $5,500, or $6,500 if age 50 or older, for 2018. Income will determine eligibility for a full or partial Roth IRA contribution, as described in IRS Publication 590-A, Contributions to Individual Retirement Arrangements (IRAs). Individuals can make Roth IRA contributions if their modified adjusted gross income does not exceed these amounts.

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Contribution limits for employer-sponsored retirement plans are much higher. The statutory salary deferral limit is $18,500 for 2018, plus $6,000 for catch-up contributions, and employers may also contribute. Fortunately, the laws and regulations for Roth IRAs provide other methods to fund Roth IRAs, including rollovers from these higher balance retirement plan accounts.

Retirement Plan Rollovers

Rollovers generally can be made from two types of retirement plan accounts–traditional pretax accounts and designated Roth accounts (e.g., Roth 401(k) accounts). But not all plans offer the Roth option.

401(k) Accounts

Employees who have built up savings in their 401(k) plan or other retirement plan accounts and who have a triggering event as defined by the plan can consider a rollover to a Roth IRA. The pretax assets in these accounts become subject to income tax for the year they are rolled over to a Roth IRA, but the 10 percent early distribution penalty tax that applies to individuals under age 59½ does not apply to these rollovers.

Rollovers from these accounts to Roth IRAs can result in a substantial tax hit if the individual rolls the entire balance over in one year, but this can be done over a number of years. For example, an eligible individual could roll over $10,000 to a Roth IRA each year until the entire balance is rolled over. There is no restriction on the number of rollovers that can be done from retirement plan accounts to IRAs.

Roth 401(k) Accounts

Since 2006, 401(k) plan participants have had opportunity to gain the Roth-like tax benefits by contributing to designated Roth accounts under the 401(k) plan (i.e., Roth 401(k) accounts), if the plan includes a Roth option. This later became available to 403(b) and governmental 457(b) plans as well.

Retirement plan participants who have invested in designated Roth accounts and meet a triggering event under the plan can roll over these Roth account assets to Roth IRAs. Because the contributions went into the Roth account on an after-tax basis, they are not subject to income tax when rolled over to a Roth IRA. And if the participant meets the retirement plan qualified distribution requirements, the earning portion rolled over also is non-taxable. If these requirements are not met at the time of rollover, earnings may attain tax-free status while subsequently in the Roth IRA.

Traditional IRA Conversions

IRA owners can convert their Traditional IRA assets to Roth IRAs. Similar to plan rollovers to Roth IRAs, the amount representing pretax assets in the Traditional IRA becomes subject to income tax for the year it is converted to the Roth IRA, but the 10 percent early distribution penalty tax does not apply. Any basis in the Traditional IRA (e.g., nondeductible IRA contributions, retirement plan rollovers of after-tax assets) is not taxable when converted.

Individuals should consider the benefits of both retirement plan rollovers and Traditional IRA conversions to Roth IRAs, and weigh the differences when deciding if such transactions meet their savings strategies. If they are near retirement, for example, their financial advisor might say a conversion is not beneficial because of the individual’s current income tax bracket and the amount of time before he needs to access the savings.

Backdoor Roth IRA

One other tax saving strategy to fund a Roth IRA is what some call the “backdoor Roth IRA.” Individuals should discuss this with their advisors because this strategy may warrant some caution.

If an individual doesn’t already have a Traditional IRA and has too much income to qualify for Roth IRA contributions, he could make nondeductible contributions to a Traditional IRA—by election or because of deduction eligibility restrictions—and then later convert the assets to a Roth IRA. Such transactions would trigger income tax only on the amount of earnings that accumulated before the conversion. If the individual already has Traditional or SIMPLE IRA assets, he’ll need to consider the pro rata aggregation rules associated with IRA distributions; he will not be able to convert only the nondeductible amounts.

Before 2010, there were income restriction associated with Roth IRA conversions, but that law was repealed and since then, anyone can do conversions. This opened the back door for high income earners to fund Roth IRAs. Doing these too often or converting too soon after the contributions are made, however, might cause complications with the IRS. While the strictest interpretation of the laws allow for this, the IRS may have concerns about abusive tax transactions and this backdoor Roth IRA strategy could cause some questions.

It is unclear how long the backdoor Roth IRA strategy will be available. President Obama proposed in his 2016 budget recommendations to eliminate it, but that did not become law. The Trump administration has not yet again addressed it.