Non-Deductible IRA: A Backdoor Roth for U.S. Expat High-Income Earners
This article is for general informational purposes only and is not intended as specific tax advice. Please consult your tax advisor for advice relevant to your situation.
For the many U.S. expats who are high-income earners and therefore effectively shut out from making traditional deductible IRA contributions or Roth contributions, making non-deductible contributions to an IRA may afford a backdoor to a Roth.
Contributions to IRAs are subject to the following income limits in 2011:
- At a minimum, all types of IRA contributions (deductible, non-deductible, and Roth) require the contributor to have earned income that is not excluded.
- If you contribute to a U.S.-qualified company pension plan such as a 401(k), deductible IRA contributions are phased out for single filers for AGIs between USD 56,000 – USD 66,000 and between USD 90,000 – 110,000 for joint filers. If you are not contributing to a U.S.-qualified pension plan, there is no upper income limit for making deductible contributions.
- Regardless of whether you contribute to a U.S.-qualified company pension plan, Roth contributions are phased out for MAGIs between USD 107,000 – USD 122,000 for single filers and USD 169,000 – USD 179,000 for joint filers.
Income Limits on Roth Conversion Eliminated in 2010
Previously, Roth conversions were restricted to those with a MAGI less than USD 100,000. This meant that many U.S. expat high-income earners not only were prevented from making deductible IRA or Roth contributions, but were also prevented from converting existing IRA balances to Roth IRAs.
This changed in 2010 when the IRS eliminated the income restrictions on Roth conversions and perhaps unintentionally opened a backdoor to Roth contributions for those above the income limits for direct contributions.
Backdoor Roth Contribution
While there are upper income restrictions on deductible IRA contributions, there are no such restrictions on non-deductible contributions. US expats who are high income earners can make a non-deductible contribution to an IRA and then convert those contributions to a Roth, effectively getting around the income restrictions on direct Roth contributions.
Only the earnings between the time of contribution and conversion would be taxable at ordinary income rates. As most conversions would occur within a short period of time, the tax consequences should be minimal.
Before employing this strategy, there are a number of considerations. Additionally, this strategy will make sense for some and not for others. Consult your tax advisor to determine if you can benefit from this opportunity.
- Before funding a non-deductible IRA, make sure you are funding any employer-provided retirement plan first.
- Only consider the non-deductible contribution if you are not eligible to make a deductible IRA contribution or contribute to a Roth.
- You must have earned income to contribute. For expats, that means you must have earned income above and beyond exclusions such as the foreign earned income and foreign housing exclusions.
- If your spouse is not able to contribute to an IRA, you may be able to make an additional contribution to a spousal IRA provided you have sufficient unexcluded earned income and your filing status is married filing jointly. This can double the amount you can get into a Roth.
- There seems to be some dissension among tax experts as to how long you need to wait from making the contribution to doing the rollover. Some argue that the conversion can be immediate. Others recommend waiting until the next calendar year. Make sure you consult your own tax advisor to make the right decision for you.
- If you already have a traditional IRA, you cannot just designate your non-deductible contributions for conversion to a Roth even if it is in a separate account. Only the pro-rata proportion of your non-deductible contributions to your aggregate IRA balances would be converted tax-free to a Roth. The rest would be taxed as a rollover of your existing pre-tax IRA contributions.
For example, assume you make a USD 10,000 non-deductible contribution to an IRA for you and your spouse and have an aggregate balance across several deductible IRAs (consisting of deductible contributions and earnings) of USD 90,000. After making the USD 10,000 contribution you want to convert to a Roth. Of the USD 10,000 conversion, the IRS will consider, USD 1,000 (10,000/100,000*10,000) to come from the non-deductible contributions and USD 9,000 (90,000/100,000*10,000) to come from your other IRAs consisting of pre-tax contributions and earnings. This portion (USD 9,000) of the conversion would be subject to tax at ordinary income rates.
So, if you have large outstanding IRA balances, this strategy will not make sense.
- You will need to file Form 8606 with your tax return, which tracks your non-deductible contributions. Make sure you retain this form for your records so you can keep track of your pretax and after-tax contributions and avoid the risk of paying tax twice on the after-tax contributions.
Who Can Benefit?
The IRS may have handed U.S. expats who are high-income earners an unintended opportunity. Those who can benefit the most are those who are shut out of deductible IRA and direct Roth contributions, have unexcluded earned income, and have relatively small existing IRA balances. Those with large existing IRA balances are unlikely to benefit significantly from this strategy. Check with your tax advisor to see if this strategy makes sense for you.