ARCHIVED BLOG, PLEASE NOTE: The information below was posted prior to any affiliation with LPL Financial and is posted here for historical purposes only
Ok, maybe shouldn’t is too strong of a word. The intention of this post is to share with you why there is most likely no reason for you to jump through hoops of making a backdoor Roth contribution when a far easier (and more impactful) option exists.
Let’s take a step back for those of you have never heard of this concept. From a very broad perspective, there are two types of retirement savings accounts. The first type is a pre-tax savings account such as a Traditional IRA or your University of Michigan 403B Base plan. Your contributions are deductible on the current year’s tax return, the account grows tax-deferred over time, and when you go to take income in retirement it is 100% taxable. The second type is a Roth savings account, such as a Roth IRA. Your contributions are not tax deductible in the current year, it still grows tax-deferred, and (most importantly) when you go to take income in retirement it is 100% tax-free. That includes both your contributions AND all earnings growth in the account.
Hopefully, this information has you wondering how you can take advantage of Roth savings. Before you start researching how to open a Roth IRA, I should stop you. Due to the great benefits of Roth IRAs, the IRS has put limits on both how much can be contributed in a given year and who is eligible to use them. If you are a couple filing your tax return jointly, your Modified Adjusted Gross Income must be less than $193,000 to contribute the full amount. If you are filing your taxes ‘single’ or ‘head of household,’ your Modified Adjusted Gross Income must be less than $122,000 to contribute the full amount ("Amount of Roth IRA Contributions That You Can Make For 2019", 2018). To verify how this applies to your unique situation, please reference the IRS Roth Contribution Guide for 2019. If you happen to fall within the income limits, the IRS will still limit your contributions to $6,000 per year if you are younger than 50 and $7,000 per year if you are age 50 or older (“Retirement Topics - IRA Contribution Limits”, 2018).
For many reading this post, this may leave you feeling like making Roth contributions is not possible. This leads back to the original discussion: backdoor Roth contributions. This is a workaround that many high-income earning professionals have chosen to utilize. The professionals would start by making a non-deductible IRA contribution in a given year. Early the next year, they would then elect to convert this new IRA to a Roth IRA. Congrats! You just successfully made a Roth IRA contribution even though you exceeded the income limits. But wait! There is one very important IRS rule that hasn’t been addressed. These transactions will only provide preferential tax treatment if the IRA contribution being converted accounts for 100% of your total pre-tax IRA balances. However, if you have other IRAs (i.e. a Rollover IRA from an old employer 403B plan) the IRS imposes something called pro rata rules. The IRS calculates your proportion of after-tax IRA balances relative to your pre-tax IRA balances.
Let’s review an example
After reading about backdoor Roths for the first time, Dr. Bob contributes $6,000 to a non-deductible IRA. In January of the next year, he quickly converts the full $6,000 to a Roth IRA. However, Dr. Bob already has a $100,000 IRA that was previously rolled over from an old 403B plan. Because the $6,000 non-deductible IRA only makes up 8.9% of his total IRAs, the IRS will tax 91.1% of the conversion. If he didn’t have the other IRA, 0% of the transaction would be taxable.
Let me stop and summarize what we have determined up to this point. Yes, you can find a way to save money into a Roth IRA even if you are over the income limits. However, it is generally not worthwhile unless it is the only IRA you own. You would be limited to $6,000 or $7,000 per year. This process includes the hassle of opening and funding a non-deductible IRA each and every year followed by completing the conversion to the Roth IRA each year.
As a University of Michigan employee, here is why you do NOT need to waste your time jumping through these hoops. You are probably already aware that your 403B Base contributions of either 4.5% or 5% of your income are contributed on a pre-tax basis. If you choose to contribute over and above this amount, you can utilize the 403B Supplemental plan. You now have the choice of whether to make these contributions on a pre-tax basis or an after-tax basis. Your combined contributions between the Base
Let’s go back to the example of Dr. Bob
Let’s assume Dr. Bob is making $130,000 in 2019, and he is 35 years old. The total of his 403B Base contributions would equal $6,500 for the year (5% of $130,000). He is eligible to save another $12,500 to his 403B Supplemental plan, and he can opt for that full amount to be ROTH contributions. This is more than DOUBLE what he would have been able to save through a backdoor Roth.
It doesn’t stop there! As a University of Michigan employee, you also have access to a 457 plan. Similar to the 403B Supplemental plan, you are able to choose whether to save into this plan on a pre-tax basis or an after-tax basis. It also happens to have an entirely separate IRS contribution limit of $19,000 for the year.
Back to Dr. Bob
In addition to the $6,500 saved to his pre-tax 403B Base and $12,500 saved to his Roth 403B Supplemental, he could also save $19,000 into his Roth 457. This is a total of $31,500 saved on a Roth basis in one single year. It would take over 5 years to save this much through a backdoor Roth!
Maybe it’s time to ask yourself why you would go through all the paperwork, technical details, and IRS hurdles of a backdoor Roth when you are a few clicks on Wolverine Access away from a far greater benefit! No income limits. Larger contribution limits. Less paperwork. What are you waiting for?
If you are interested in learning more about whether or not this strategy is appropriate for you, please feel free to contact me at emily@university-wealth.com.
Resources
Amount of Roth IRA Contributions That You Can Make For 2019. (2018, November 02). Retrieved January 25, 2019, from https://www.irs.gov/retirement-plans/amount-of-roth-ira-contributions-that-you-can-make-for-2019
Retirement Topics - IRA Contribution Limits. (2018, November 02). Retrieved January 25, 2019, from https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-ira-contribution-limits
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