During 2017, working individuals – and this includes all federal employees – could be eligible to contribute as much as $5,500 (if they are under age 50) and $6,500 (if they are over age 49) to a Roth IRA. With a Roth IRA, contributions are not deductible but earnings grow tax-free provided the earnings are withdrawn after the Roth IRA owner becomes age 59.5 in a qualified withdrawal. But those individuals whose modified adjusted gross income (MAGI) exceed the IRS specified limits during 2017 are ineligible to directly contribute to a Roth IRA. This column discusses how these individuals can indirectly contribute to a Roth IRA through a “backdoor” strategy.
The following table summarizes the MAGI limits for individuals who want to contribute to Roth IRAs during 2017. The MAGI limits depend on an individual’s tax filing status:
Consider the following example:
Stephanie, a Federal employee, single and expects to have a MAGI of $140,000 during 2017. Since Stephanie’s 2017 MAGI exceeds $133,000, Stephanie is not eligible to contribute to a Roth IRA for 2017.
The Basics of Nondeductible Traditional IRAs
A nondeductible traditional IRA has the same contribution limits as a traditional deductible IRA. The difference is how the contribution is treated on the IRA owner’s Federal income tax return for the year of contribution.
During 2017, an individual younger than age 50 can contribute a maximum $5,500 to a traditional IRA. If the individual is over age 49 as of Dec. 31, 2017, the individual can contribute a maximum $6,500. Note that while these contribution limits are the same for the Roth IRA, an individual can contribute no more than $5,500 (younger than 50) or $6,500 (over age 49) in total to a combination traditional IRA (deductible and nondeductible) and Roth IRA for 2017.
When an individual contributes to a nondeductible traditional IRA, the individual needs to file IRS Form 8606 (Nondeductible IRA) to report the amount of the IRA contribution that was nondeductible. The nondeductible portion of the IRA is called the IRA owner’s “cost basis” in the IRA. In establishing the IRA cost basis, the IRA owner will not have to pay tax when the IRA contributions are either withdrawn or converted to a Roth IRA.
Using a Nondeductible Traditional IRA Contribution to Make a “Backdoor” Contribution to a Roth IRA
Those federal employees whose 2017 MAGI exceeds the limits as presented in the table above and therefore not eligible to make a Roth IRA contribution can still “contribute” to a Roth IRA via the “backdoor”. The process works as follows: Each year the employee (must be younger than age 70) contributes to a nondeductible traditional IRA (that has no MAGI limitations) and then converts the nondeductible traditional IRA to a Roth IRA. The conversion ideally should be done in the same year that the contribution is made and shortly thereafter.
When a traditional IRA owner converts the traditional IRA to a Roth IRA, the owner must pay taxes on any amount converted that exceeds the IRA owner’s cost basis. While this seems straightforward, the IRS does not allow IRA owners to “cherry pick” their traditional IRAs, isolating the one IRA to convert using only its cost basis. The cost basis must be calculated using a pro-rata formula incorporating all of the IRA owner’s traditional IRAs, as presented in the following example:
Joseph owns four deductible traditional IRAs currently worth $20,000. He also owns two nondeductible traditional IRAs in which he contributed $5,000 to each and are currently worth $20,000. Joseph therefore has a total of $40,000 in traditional IRAs, of 25 percent ($10,000) consists of nondeductible contributions (Joseph’s traditional IRA cost basis) and the other 75 percent ($30,000) has zero cost basis.
It would be ideal from a tax standpoint if Joseph could convert only the nondeductible IRA proportion ($10,000). But the IRS is looking at all of Joseph’s traditional IRA accounts combined. That means if Joseph’s $10,000 of nondeductible traditional IRA contributions are converted to a Roth IRA, then 25 percent of the converted amount ($2,500) will be considered cost basis (nontaxable income) and the other 75 percent ($7,500) will have zero cost basis, and will be considered as fully taxable income for the year of Roth IRA conversion.
How Federal Employees Can Avoid the IRS’ “Pro-Rata” Rule
The “pro-rata” basis rule does not apply if a traditional IRA owner has all of his or her other retirement money in a defined contribution plan such as a 401(k) plan or the Thrift Savings Plan (TSP). In that case, when an individual contributes to a nondeductible traditional IRA, immediately converts the contribution to a Roth IRA and files Form 8606 with his or her income taxes that year, then the full amount of the conversion is considered to have come from something that has cost basis and therefore considered nontaxable income. Consider the following example:
Paula has $600,000 in her TSP account and owns no IRAs. Paula is single and her MAGI during 2017 is too large resulting in her being ineligible to contribute to a Roth IRA. But Paula can contribute to a nondeductible traditional IRA and immediately convert to a Roth IRA, resulting in no tax due.
Those federal employees who own traditional IRAs with no cost basis – this includes deductible traditional IRAs and the accrued earnings in nondeductible traditional IRAs for which Form 8606 was filed, can be transferred into one’s traditional TSP account with no dollar limitation using Form TSP-60 (Request for a Transfer Into the TSP). In so doing, the employee will be left with traditional IRAs with cost basis. The employee can then use the “back door” Roth IRA conversion strategy, converting nondeductible traditional IRA contributions without worry for paying taxes on a “pro-rata” basis.
In short, a federal employee who is ineligible to contribute to a Roth IRA should first transfer his or her traditional IRAs, including SEP IRAs and SIMPLE IRAs, into his or her traditional TSP account via Form TSP-60. In so doing, they will be able to utilize the “back-door” Roth IRA strategy and avoid paying Federal and state income taxes in the Roth IRA conversion process.