Generally, if you believe you will be in a higher tax bracket in retirement, it makes sense to do a Roth IRA rather than a traditional IRA. However, there is a problem. There are income limits to do a Roth IRA.
In 2021, if you are married and your combined modified Adjusted Gross Income (AGI) is above $206,000 ($139,000 for single), you cannot contribute to a Roth IRA directly.
Don’t worry though because the IRS has allowed a different way to do a Roth IRA for high-income earners and it is called backdoor Roth IRA. In this article, I talk about how you can do a backdoor Roth IRA. So, if you are a high income earner and want to save and invest money in a tax-friendly way, then this article is for you. If your modified AGI is below the $206,000 limit for married filing jointly (or $139,000 for single), you can stop reading this article and you can open a Roth IRA for yourself and your spouse now.
Make no mistake. Investing in a Roth IRA for a high-income earner over your work-life can save almost a million dollar in taxes. So, if you are reading this article and feel that this is way too complex, remember two things
- It sounds complex on paper but once you go through these steps, it is pretty straight forward.
- Doing a backdoor Roth IRA is really worth the effort. Once again, the tax savings can be huge. In this example, a person earning $72,000 a year can have tax-free gains of over one and a half million dollars if invested through Roth IRA.
So, how can you invest in a Roth IRA when you are a high-income earner and you don’t meet the income limit requirements posted by the IRS. These are the steps I follow each year to do a backdoor Roth IRA.
- Make sure that you don’t have any other IRA account (Traditional IRA, SIMPLE or SEP-IRA). If you have one of these accounts, consider rolling them to your 401K before you do a backdoor Roth IRA.
- Open a Traditional IRA account and open a Roth IRA account, preferably at the same broker. I have my accounts at ETrade, but you can do this at any broker (Fidelity, Schwab or TDAmeritrade).
- Make a Non-Deductible contribution to the Traditional IRA. This amount changes every year. For 2020 and 2021, this amount is a maximum of 6,000 (7,000 if you are 50 or above) per year. Since you are a high-income earner, you won’t be able to deduct this in your tax return. That is why this is called a Non-Deductible contribution.
- Wait for a few days for the funds to clear and don’t invest in any securities yet. After a week or so, convert those funds to the Roth IRA account that you opened in Step 2. Usually, you can do this step electronically, but if you need some hand-holding, call your broker’s customer service and they should be able to help you.
- When you file your taxes, remember to file a Form 8606 to record that you made a non-deductible contribution to the traditional IRA and converted it to Roth. If you use a tax-preparation software, it will automatically file that form for you if you input this information in the software.
Once you do this, you can start investing that contribution through your Roth account. Any gains and losses in that account will never show up in your tax return, so invest wisely and don’t make short-term bets because you won’t be able to write-off those losses in your taxes.
Any amounts invested through Roth will be in a tax-free basket and these amounts will never be taxed if you follow some rules. There are no Required Minimum Distributions (RMD) on a Roth IRA, which is one of the disadvantages of a Traditional IRA. So you won’t be forced to withdraw money from your IRA in your retirement years.
The “I” in the Roth IRA stands of Individual, so you can do a Roth both for you and your spouse. You just need earned income to do a Roth IRA. Only one spouse can be the earner and you can still do a Roth for both spouses on one earned income.
Once you follow this process, you can do it every year. Just make sure to convert the entire traditional IRA to the Roth IRA, that way you won’t have to pay taxes in later years. So your traditional IRA account will have a zero balance pretty much the entire time except during conversion.
You have until the tax filing date (usually Apr 15 of next year) to complete this process. So, if you are reading this article before Apr 15, 2021, you can still do this for 2020.
Are you saving for your retirement? Are you using Traditional or Roth IRA? Are you already doing a backdoor Roth IRA? Feel free to comment below.