Taxpayers with incomes above certain limits are unable to contribute to a Roth IRA. In 2013, this limitation starts at $178,000 (modified adjusted gross income – essentially, the last line on page 1 of Form 1040) for married taxpayers and $112,000 for single taxpayers.
All is not lost however, at least for some.
Taxpayers with incomes above the limitation amounts may be able to take advantage of a “back door” Roth IRA in certain circumstances. It is available to people who have only contributed to an employer retirement plan, such as a 401(k) or 403(b), and have not established a traditional IRA with pre-tax money or rolled an old employer plan into a self-directed IRA.
The first step in funding the back door Roth contribution is to make a non-deductible contribution to a traditional IRA. This will create “tax basis” for you. The second step is to convert this traditional IRA to a Roth IRA. Since the traditional IRA has a tax basis equal to the contribution, the conversion is tax-free. Finally, the money that is now in the Roth IRA can be invested in accordance with your risk tolerance.
Each subsequent year you may repeat this process: Fund a traditional IRA, convert the traditional IRA to a Roth IRA, and then invest the contribution. Note that you cannot, unless your income is below the Roth IRA contribution income limits, contribute directly to your Roth IRA. The contribution must always be indirect, through the traditional IRA first.
Higher income earners who have made of all their retirement contributions to an employer plan are the best candidates for this technique. This is common for younger workers in professions where the earnings start at or rapidly exceed the Roth IRA contribution limits, such as those in medicine, or law. It can also benefit workers who have been with the same employer for a number of years and have never funded a traditional IRA.
Caution must be taken to follow the proper steps. If done as described, however, this technique can provide another savings option for some who would otherwise be unable to contribute to a Roth IRA.
