You can take contributions to the max for both your 401(k) and a Roth IRA -- a great way to diversify your retirement savings —--but first you must have a pretty good estimate on your modified adjusted gross income, or MAGI. That determines whether the Roth deposit enters your account through the front or back door.
Your 401(k) contributions will be completed by year's end, but you have until the normal tax-filing deadline – typically April 15, but it could be a day or two later – to make an IRA contribution, including for a Roth IRA. Even if you file for an extension, your IRA contribution still must meet the regular tax-filing deadline.
The IRS can change contribution limits annually. Starting in 2012, the max for 401(k) contributions was pegged at $17,000. IRA contributions -- the total for both traditional and Roth IRAs -- were limited to $5,000. But folks 50 and older could put another $5,500 into a 401(k) and $1,000 more into an IRA. Those are called catch-up contributions. Of course, you might not need to catch up if you hit the maximums for 25 years before your 50th birthday.
For people with access to a 401(k), the IRS sets income limits annually for Roth contribution eligibility. In 2012, for example, the MAGI limit was $110,000 -- or $173,000 for couples filing jointly -- for a full Roth contribution. If your MAGI topped $125,000, or $183,000 for couples, you could make no direct contribution to a Roth. Because 401(k) contributions are pretax, your MAGI drops dollar for dollar when you put money into your company's plan.
Even if you can't make a full Roth contribution, you can make a proportionate one if your MAGI falls between the two income thresholds. It's not difficult to calculate your contribution percentage. Subtract your MAGI from the disqualifying Roth contribution income limit. Then divide the difference by $10,000 if you file jointly or by $15,000 if you're single. For example, if you're married with a MAGI of $176,830, you would be eligible for a 61.70 percent contribution. That's $3,085 if you're under 50 or $3,642 if you're in the catch-up age bracket.
There's a way around the income restrictions. Anyone can make after-tax traditional IRA contributions, and the IRS puts no MAGI limits for converting an IRA to a Roth. So, you can make a full nondeductible contribution to a regular IRA. Then, if you convert it immediately to a Roth, the transfer will be tax-free if your after-tax contribution constitutes your entire IRA assets.
A conversion must be completed by Dec. 31 to be included on that year's tax return. If you wait until you've figured your MAGI -- sometime between Jan. 1 and April 15, 2013, for example -- to initiate a tax-free backdoor strategy, the contribution would be reported on your 2012 return, but the conversion would go on your 2013 return with no tax consequences.
If you have any IRA account with deductible contributions or tax-deferred earnings -- including a rollover from a previous employer's 401(k) plan -- the contribute-and-convert process becomes more complex. The IRS doesn't allow you to select only after-tax contributions in a conversion or permit you to initiate a separate IRA as a conversion pass-through. The tax-free part of a conversion gets based on the percentage of after-tax contributions in the total balance of all your IRA accounts. For example, if you have $45,000 in tax-deferred IRA assets and you add a $5,000 after-tax contribution, only 10 percent of any Roth conversion would be considered tax-free. The remaining 90 percent would be added to your ordinary income.
IRA Escape Route
There's a potential workaround for your backdoor Roth contribution, particularly if your other IRA assets came as a result of a rollover from your 401(k) with a previous employer. If it's allowed at your current job, first roll all those IRA assets into the 401(k) plan you have now. Then proceed with the backdoor Roth strategy. Words of caution, however: A reverse rollover typically goes only one-way. Once you roll money into your current plan, you won't be able to get that money out until your leave your current employer.
- Internal Revenue Service: Publication 590, Individual Retirement Arrangements (IRAs)
- Internal Revenue Service: 2011 IRA Contribution and Deduction Limits
- Tax Guide for Investors: Basic Rules for Regular Contributions
- Morningstar: Backdoor Roth IRAs Could Cost Some Investors at Tax Time
- Morningstar: The Ins and Outs of IRAs -- Income and Contribution Limits
Dale Bye has spent more than 40 years in journalism, including 25 supervising reporters and editors at metropolitan newspapers and eight years as senior managing editor at a national sports magazine. He directed five newspaper-sponsored personal finance fairs. His fields of expertise include business and personal finance, sports, fitness and theater. Bye holds a Bachelor of Journalism from the University of Missouri.