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IRAs

How to Contribute to a Roth IRA If You Earn Too Much

High incomers can use the "backdoor" Roth strategy, but beware the pitfalls.

Want to put money into a Roth IRA but your income exceeds the thresholds for contributions? You can employ the "backdoor" Roth strategy.

 

That's a way Paul Missel is building a tax-free pot of retirement money. Missel, 59, works for a pharmaceutical company in Fort Worth, Tex., and his income is too high to make direct contributions to a Roth. Instead, he makes nondeductible contributions to a traditional IRA and later converts the money to a Roth. There are no income limits for conversions.

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Missel is a big Roth fan because the money grows tax free, and he will not have to take required minimum distributions when he turns 70 1/2, as he would with a traditional IRA. "It's the tax liability of RMDs that's driving me forward doing this," he says.

Singles with adjusted gross income of more than $131,000 in 2015 (more than $193,000 for joint filers) cannot contribute directly to a Roth IRA. Taxpayers who are younger than 70 1/2 can contribute to a traditional IRA -- up to $6,500 in 2015 for those 50 and older. You can convert contributions at any age.

Because those nondeductible contributions already have been taxed, the money can be converted tax free. But there's a hitch if you also have deductible IRA contributions, says Wade Chessman, of Chessman Wealth Strategies, in Dallas. In that case, the pro rata rule comes into play, and thus only a portion of the Roth conversion would be tax free.Here's how the pro rata rule works: You must figure the ratio of your nondeductible contributions to the total held in all of your traditional IRAs. Only that percentage of a conversion will be tax free. If you have $10,000 of nondeductible contributions and $90,000 in deductible contributions, just 10% of a conversion is tax free. You will owe ordinary income tax on the rest.

Working Around the Pro Rata Rule

But some workers may be able to circumvent the pro rata rule with what financial planner Kevin Reardon calls a "401(k) rollup." If you participate in a 401(k) plan that allows you to roll IRA money into it, you can move all your deductible contributions and any pretax earnings into the 401(k). Because employer plans only accept pretax money, just the nondeductible contributions will be left in your IRA -- and you can do a tax-free conversion to a Roth, says Reardon, founder of Shakespeare Wealth Management, in Pewaukee, Wis.

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Reardon says the 401(k) rollup is an ideal move for investors who've made nondeductible contributions over the years. Perhaps you own one IRA with $50,000 of nondeductible contributions that have grown to $80,000. The $30,000 of pretax growth would go into the 401(k), and the $50,000 of nondeductible contributions would be converted to a Roth tax free. (The self-employed can do this strategy, too, with a solo 401(k).)

Another way to sidestep the pro rata rule: If your nonworking spouse doesn't have a traditional IRA, you could make nondeductible contributions to a spousal IRA for her. She can then convert the money to a Roth tax free. Because IRAs are not joint accounts, the husband's traditional IRAs aren't counted with hers when tallying up the wife's traditional IRA balances, says Michael Kitces, the director of planning research at Pinnacle Advisory Group, in Columbia, Md.

Whatever way you use the strategy, you want to show that each move is independent of the other -- and waiting between the two steps is a way to do that. But advisers differ on how long you should wait.Kitces says he advises his clients to hold off for a year. However, the longer you wait, the more the account may grow, which will increase your tax bill on the earnings when you convert. But assuming you plan to keep the money in the Roth for a number of years, Kitces says, "the fact you waited a year is irrelevant."

Jeffrey Levine, IRA technical consultant with Ed Slott and Co., suggests waiting one statement cycle. The paperwork will show the money was put into a traditional IRA first, and you can get the money into a Roth sooner for tax-free growth.

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