How can I fund A Roth IRA if my income is too high to make direct contributions?

Although Roth IRAs provide many advantages for lower- and middle-income retirement savers, those with modified adjusted gross incomes (MAGI) above a certain amount are subject to a contribution phase-out schedule, adjusted for inflation each year, that eventually disallows direct contributions. In 2014, the schedule for married taxpayers filing jointly is $181,000-191,000; for Single and Head of Household filers, it's $114,000-129,000. Individuals with incomes above the top number in each category cannot contribute to a Roth.

However, all is not lost for those who exceed the limit. The removal of the $100,000 MAGI limit for Roth conversions in 2010 created a loophole in the tax code that allows high-income filers to legally funnel money into Roth accounts using a “back door IRA” strategy. Here's how it works:

1. Open a traditional IRA with your IRA custodian of choice. (It is usually easiest, but not necessary, to use the same custodian that holds your Roth conversion IRA – or where you plan to open your Roth.)
2. Make a fully nondeductible contribution to your traditional IRA. The contribution limits in 2014 are $5,500 for those under age 50, plus an additional $1,000 catch-up contribution for those aged 50 and above. If your MAGI exceeds the Roth limit, as described above, you are automatically ineligible to deduct your contribution if either you or your spouse – if you're married – participates in an employer-sponsored qualified plan of any kind. If neither you nor your spouse is a qualified-plan participant, simply refrain from reporting your traditional IRA contribution as a deduction for MAGI on your 1040.
3. Next, convert the traditional IRA balance into a Roth IRA. Because the MAGI threshold for contributions does not apply to conversions, the income limitation is effectively thwarted.
4. Repeat this process every year that your MAGI is too high to allow you to make a direct contribution to your Roth IRA.

Taxes and Other Considerations

This back-door strategy works best if you don't already have a traditional IRA because it will leave you owing no taxes on your contribution. If you do have a traditional IRA that you have funded with contributions for which you took a deduction, however, the tax benefit will be reduced and computing your taxes becomes more complicated. Understanding this takes time, but it’s worth paying attention to the following three situations – or discussing them with your tax advisor.

Situation 1: You Owe Zero Taxes

You are 40 years old and make $200,000 a year. You open a new IRA and make a nondeductible $5,500 contribution. You then convert this $5,500 to a Roth IRA. You have no other traditional IRAs. Your tax bill for the conversion is zero because you did not deduct your contribution.

Situation 2: You Owe Taxes on All Your Previous IRA Balances

Your actions and circumstances are identical to Example 1, except that you also have a traditional IRA rollover account that was funded entirely with deductible contributions: You got a tax deduction when you made the contribution. If you try to convert the entire amount you have in IRAs – both this year's $5,500 nondeductible contribution and the rest of your IRA balance – you will have a tax bill. How much you owe depends on how large that rollover IRA is.

If the IRA is worth $49,500, $4,950 of your $5,500 would be taxable:

Nondeductible contribution to traditional IRA = $5,500

IRA rollover balance = $49,500

Total of contribution plus IRA balance = $55,000 ($5,500 + $49,500)

$5,500/$55,000 = 0.1 = 10%

$5,500 x 10% = $550 nontaxable conversion balance

$5,500 - $550=$4,950 taxable conversion balance

Only the $550 will be subtracted from the total contribution as nontaxable.

If the IRA is worth $3,000, only $1,925 would be taxable.

Nondeductible contribution to traditional IRA = $5,500

IRA rollover balance = $3,000

Total of contribution plus IRA balance = $8,500 ($5,500 + $3,000)

$5,500/$8,500 = 0.65 = 65%

$5,500 x 65% = $3,575 nontaxable conversion balance

$5,500 - $3,575 = $1,925 taxable conversion balance

If you have one or more IRAs that you funded with deductible contributions, even the back-door strategy cannot keep you from owing taxes on a Roth conversion. You can't open a second IRA and roll over only that second account and owe no taxes, as in Situation 1. Your Roth IRA, by the way, will just have the $5,500 in it; your other IRAs won’t be folded into it; they’ll just be included in the government’s tax calculations. The tax bill will be assessed regardless of whether a new or current account is used.

Situation 3: You Owe Taxes Only on Some IRAs

For a back-door Roth conversion, the government will calculate taxes only using IRA balances funded with deductible contributions. These will not be included if you have IRA balances you funded with after-tax (nondeductible) contributions.

Imagine you are the same age with the same income as in the previous examples. You could have several IRAs that were funded partly with deductible contributions and partly with nondeductible contributions. For the sake of simplicity, though, imagine you have just two traditional IRAs, one funded each way:

IRA #1 - $60,000 – funded with deductible contributions

IRA #2 - $40,000 – funded with nondeductible contributions

You open a third traditional IRA with a $5,500 nondeductible contribution and convert that balance to a Roth IRA. Your tax calculation would only include IRA #1, the deductible-contributions IRA.

Nondeductible contribution to traditional IRA = $5,500

IRA #1 = $60,000 (total IRA balance made with deductible contributions)

$5,500 + $60,000 = $65,500

$5,500/$65,500 = 0.08 = 8%

$5,500 x 8% = $440 nontaxable conversion balance

$5,500 - $440 = $5,060 taxable conversion balance

Situation 4: One Other Way to Escape Taxes

If you or your spouse participates in a traditional qualified plan at work that accepts rollovers of pretax (deductible) IRA balances, then you have another avenue with which you can avoid tax when you use the back-door strategy to fund a Roth. Here’s how: Roll over all your deductible IRAs before starting the conversion process. Then, open a new IRA with a $5,500 nondeductible contribution and convert that amount into a Roth IRA. Your tax bill will be zero because the government doesn’t include qualified-plan balances in calculating the tax on a backdoor Roth conversion. It also excludes IRAs made with nondeductible contributions from the calculation.

The Bottom Line

You can use the back-door strategy to get into a Roth IRA in all these situations. You save the most if you do not have preexisting traditional IRA balances that must be factored into your tax bill (Situation 1) – or if your employer’s qualified plan allows you to fit into Situation 4.

Of course, this strategy is unnecessary if your employer offers a Roth 401(k) retirement plan, and you are not making the maximum possible contribution. Roth 401(k) plans let you contribute up to $17,500 for 2014 in after-tax dollars that you can collect tax-free when you retire. If you have only contributed $5,000 to your Roth account in the plan, then it would be simplest to contribute the remaining $12,500 for 2014 before opening a back-door IRA. One possible exception to this rule could be if you are dissatisfied with the investment choices that are offered inside the plan and wish to explore alternative options elsewhere.