A Roth IRA Savings Strategy for High-Income Investors

Updated: Jul 27, 2020


Raise your hand if you like paying more in taxes than you need to?  Yeah, I didn’t think so… If your answer is like most Americans and you make a sizable income, then a backdoor Roth IRA is a strategy you may want to consider. However, before explaining how to unlock this financial planning tool to your advantage, it is important to know the following Roth IRA phaseout limits set forth by the IRS:

  • Single = $117,000 - $132,000

  • Married = $184,000 - $194,000

In addition, one needs to know that when an active participant in a company sponsored retirement plan exceeds the income limits listed above, then that person (in most instances) is disqualified from making deductible IRA contributions.  The alternative for that person is to then contribute to a nondeductible IRA.  Meaning a nondeductible IRA is funded with after-tax dollars.  Therefore, the only advantage to the owner is that their money will grow tax-deferred until distributions begin at normal retirement age (59 ½).  Any growth is taxable and pulled first whenever the owner starts making withdrawals.  A Roth IRA, on the other hand, allows the owner to grow their after-tax contributions on a tax-deferred basis and take tax-free withdrawals at full-retirement.  Translation, a Roth IRA is always better than a nondeductible IRA!

You are probably wondering how does a backdoor Roth IRA fit in with all this financial mumbo jumbo?  Think of the concept this way, the “backdoor” is a smarter entry point for a person who intends to sneak in undetected.  Inserting this into the IRS’ world, an investor who exceeds the Roth IRA phaseout limits is able to use the backdoor Roth as means to bypass these limits without being accessed the typical IRS penalties

So how does a disqualified Roth investor actually slip past the IRS?  Their “backdoor way in” is, in a basic sense, a 2-step process.  The first step is to contribute to a nondeductible IRA, followed by eventually converting those funds to a Roth IRA. The timing of when that conversion occurs is important to make note of, because the IRS might take you to court and challenge your contribution if you are too careless.


Okay then… How does one avoid setting off the IRS alarms?  Actually there are two hurdles to consider when deciding whether or not a backdoor Roth strategy is appropriate for you. The first roadblock you need to evaluate is the IRA Aggregation Rule, and the second one is called the "step transaction doctrine." 

The IRA Aggregation Rule

Red alert to any investor who owns multiple pre-tax IRAs.  All of your pre-tax IRAs are treated as one account when calculating the tax consequences of a Roth conversion. In other words, the IRS’ aggregation rule requires an owner of multiple IRAs to include a proportionate amount of any pre-tax IRA balances (Traditional IRAs) with their after-tax IRA balances (nondeductible IRAs) whenever performing a Roth conversion.

Example.  An attorney, Atticus Finch, currently exceeds the IRS’ income limits to be able to contribute to a Roth IRA and also has a Traditional IRA worth $100,000.  Atticus is considering whether or not he should convert his recent nondeductible IRA contribution of $5,500 to a Roth IRA. Unfortunately, for Atticus his $5,500 nondeductible amount gets rolled in with the $100,000 of pre-tax IRA funds when he goes to complete the Roth conversion. Meaning only 5% ($5,500 / $105,500) of the conversion is sourced from the nondeductible IRA, and the other 95% comes from the Traditional IRA.  Needless to say, Atticus isn't happy because he just paid income taxes on 95% of his $5,500 after-tax conversion. While it's technically not double taxation, it sure feels like it... Yikes!  

What can Atticus do to prevent this problem? One answer is to rollover all of his Traditional IRA funds to his law firm's 401(k) retirement plan. This is because 401(k), 403(b), and other employer sponsored retirement plans are excluded from the IRA aggregation rule.  However, employer sponsored SIMPLE IRAs and SEP IRAs are truly IRAs, and therefore included for the sake of this rule.

The Step Transaction Doctrine

Another issue to be considered is the "step transaction doctrine," which allows the Tax Court to review what are, in fact, two separate steps of a transaction to be deemed one integrated tax event. The key to avoiding this is the timing element.  So when an investor deposits money into a nondeductible IRA and then converts those funds into a Roth IRA within a matter of days, the IRS may consider this a single integrated tax even.  The consequences of this are that the IRS disallows it as an excess Roth contribution and assesses the investor a penalty tax of 6%.  Keep in mind that 6% penalty accrues each year the money remains in the Roth account.  

The safest way to get around the IRS disallowing a backdoor Roth contribution is to wait at least 1-year to convert the nondeductible IRA funds to a Roth IRA.  And, a way to reinforce that both transactions are independent of one another is to invest the nondeductible funds while you wait to do the Roth conversion.  Any gains from the nondeductible IRA are taxable the following year you convert them.  However, the tax benefits of the Roth more often offset this one-time taxable event. Plus having investment gains in your account is a good thing!

Helpful tip.  NEVER put anything in writing that states what you are doing is a backdoor Roth IRA. Doing so gives the IRS ammunition if they ever question your transactions as being singular in nature.  


  • Confirm there are no other pre-tax IRAs

  • When there are, rollover funds to a 401(k)

  • Contribute to nondeductible IRA

  • Invest funds in nondeductible IRA

  • Keep money in nondeductible IRA for 1 year

  • Convert to Roth IRA

If you have further questions:

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Helpful Resources:

Backdoor Roth IRA Contribution
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