Planner’s Corner is a series of posts on financial planning topics that relate to personal experiences, preferences and opinions of the author. As with any content on this site, nothing is intended to be personal financial advice, that is after all, personal. The author recommends a fee-only CFP® for your personal plan.
A long time ago in a galaxy far far away, I found out I was ineligible to contribute to my Roth the hard way.
I made the annual contribution early in the year as I always did. Some vesting stock that was priced better than expected pushed me over the limit and I was blindsided when I started to file my taxes. I was furious I let it happen, I should have paid more attention up front.
Fidelity helped me correct things and remove the excess, but any earnings on that excess were fully taxable. It’s a headache best avoided, I will just leave it at that. Know where you stand.
First things first, if your income is too high to contribute to your Roth that is a good thing, never bad. Hopefully you were able to sock away the max for many years up to this point. This new development just means you need to take the next step and consider your options.
Taxable accounts
There is obviously no limit to what you can put in a taxable account. There are no tax benefits, or deductions, but chances are if you are over the limits the deduction part outside of your employer accounts is non-existent anyway.
At some point it becomes better to open a taxable account with a brokerage and start putting the excess to work. If you aren’t comfortable doing that, there are advisors who can help. It could be as simple as a few index funds and if you don’t sell anything for a year or more, favorable long term capital gains tax treatment on the sale will apply.
Not to mention the taxable account allows for further diversification into individual stocks or higher yielding offerings. Most people I speak to are just not comfortable with stock or ETF selection. It does get easier by the day, a few diversified ETFs is all one really needs.
Assuming I had taken full advantage of employer sponsored offerings, I would go the taxable account route if I had excess investable income well above the IRA limits. Idle cash in these accounts today are offering 4%+ which is a stark difference to 12 short months ago.
On the other hand, if you are closer to the existing IRA limits with any excess the backdoor Roth is also an option.
Backdoor Roth
Sounds like a secret concept doesn’t it? Used car salesman office with wood paneling and shag carpet type stuff. Nah, not really.
I will include some links below that discuss this in greater detail but here is the gist:
You fund a *new* traditional IRA with after-tax money, sans any type of tax deduction. Ideally it will be a new IRA account with a zero balance.
The reason for the zero balance is you are creating a taxable event on the ultimate Roth conversion. Muddling any prior pre-tax contributions (and earnings) in an existing IRA vs. new after-tax contributions and trying to separate the two for the conversion is a hot mess. I know I wouldn’t attempt it on my own, that’s for sure.
It’s a little cleaner starting with a new IRA. The maximum allowable contribution is made with after-tax money (no tax deduction) and placed into a stable investment until the conversion can be made.
Once the contribution is made, the IRS clock starts on January 1 of that year. The Roth conversion will need to be completed prior to year end and you will be taxed on that conversion at your nominal tax rate at the time of the conversion. That’s the reason you want to convert quickly, not after the account value has grown. Let if grow after the conversion.
The biggest (and really the only?) drawback I see with this well known option is tracking and paperwork. A new IRA soon to be new Roth IRA in addition to what you may already have. There are no limits to how many IRA’s you can have, traditional or Roth for that matter if you obey the limits, but do you really want to track and manage them all?
One benefit to creating some new unique IRAs is they can be used differently, provide more diversification, perhaps more aggressive (or conservative) than your primary Roth. They could also create some unique withdrawal streams later. Having multiple accounts may assist in that endeavor.
Lastly, don’t forget about the five year rule. You will need to wait 5 years, which starts on Jan 1st in the year of your contribution before you are able to make tax-free withdrawals, contributions included. Just something to keep in mind. This is different than a typical Roth IRA where contributions can be withdrawn whenever you choose.
Here are some links from trusted sources that discuss this in greater detail to help decide whether this may be an option for your situation:
https://www.fidelity.com/learning-center/personal-finance/backdoor-roth-ira
https://www.nerdwallet.com/article/investing/backdoor-roth-ira
https://www.forbes.com/advisor/retirement/backdoor-roth-ira-pitfalls
on balance
If you find yourself ineligible to contribute to your Roth IRA, remember that is not a bad thing and chances are your account reflects your prior efforts.
If you don’t mind the extra paperwork, tracking and tax implications with IRA conversions the backdoor method is still available. Just keep in mind you are creating a new account, converting it, tidying up the tax bill and you will rinse and repeat if you chose to do it again in future years.
Each newly converted Roth will be on lock down for 5 years. That may be totally fine, but keep that in mind, even contributions to a converted account are off limits for 60 months.
Finally, don’t overlook the benefits of a taxable account if you have not yet waded those waters. They can be used to supplement income via favorable qualified dividends and long term holdings will get favorable capital gains treatment should you decide to sell.
Conversions create a taxable event. You should fully understand what that conversion means to your tax bracket and overall situation. If you aren’t sure, then it’s time to get in front of a pro.
The Finance Stance 