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A backdoor Roth may let you fund a Roth IRA beyond normal limits

Quick Summary

  • A backdoor Roth IRA allows you to get around income limits by converting a Traditional IRA into a Roth IRA.
  • Contributing directly to a Roth IRA is restricted if your income is beyond certain limits, but there are no income limits for conversions.
  • The amount of money you can contribute to a Roth IRA is normally limited, but a backdoor Roth IRA has no limits on the amount of the conversion.

Introduction

Roth IRAs are a unique and powerful way to save for retirement. You pay taxes up front on a Roth IRA. After that, all growth and withdrawals are tax-free in a Roth IRA.

The problem: People who earn over a certain amount aren’t allowed to open Roth IRAs—under the regular rules, anyway. If you think tax-free income in retirement would be important to you, but you make too much to open a Roth, you might want to consider the back door. In a backdoor Roth, you first make a contribution to a Traditional IRA, then convert it to a Roth IRA.

It’s legal, but it’s a little bit more complex. Some of the commonly asked questions about backdoor Roth IRAs are:

What exactly is a backdoor Roth IRA?

A backdoor Roth is a conversion of Traditional IRA assets to a Roth IRA. Currently, anyone can convert money that they have put into a Traditional IRA to a Roth IRA, no matter how much income they earn. What’s more, they can also roll as much money as they want from an existing Traditional IRA into a Roth IRA. In other words, if the Traditional IRA has more than the yearly contribution limits on IRAs, you can roll over that larger sum into a Roth at one time.

Keep in mind: This isn’t a tax dodge. You will need to pay taxes on any money in your Traditional IRA that hasn’t already been taxed. The funds that you convert to a Roth IRA will most likely count as income, which could kick you into a higher tax bracket in the year you do the conversion. On the other hand, if your income happens to be unusually low in a particular year—perhaps you had a gap in employment—you could take advantage of that situation by making the Roth conversion then. Timing is important. Carefully calculate the tax implications of a Roth IRA conversion before you decide.

You can do a backdoor Roth IRA in one of two ways. The first method is to contribute money to an existing Traditional IRA, sell shares, and then roll over the money to a Roth IRA account. Or, you can convert an entire Traditional IRA account to a Roth IRA account. Your bank or brokerage should be able to help you with the mechanics. Your Traditional IRA doesn’t have to be new. You can roll over existing Traditional IRA money—or an old Traditional IRA account—into a Roth.

Is a backdoor Roth IRA right for me?

The main advantage of a Roth IRA is that you pay taxes up front, but everything after that is tax free. This is most beneficial when your taxes are lower now than you expect they will be in the future.

A backdoor Roth IRA lets you get around:

a) Roth IRA Income limits: In 2017, if your modified adjusted gross income (MAGI) is $133,000 [single] or $196,000 [married filing jointly or qualifying widow(er)], you may not contribute to a Roth IRA. These limits do not apply to Roth IRA backdoor conversions.

b) Roth IRA Contribution limits: Normally, you may contribute only $5,500 ($6,500 if you are age 50 or over) to a Roth IRA. With a backdoor Roth IRA conversion, these limits do not apply

If your income is beyond these limits—or if you want to contribute more to a Roth than is allowed within one year—a backdoor Roth IRA is the only way to do so.

What are the tax implications of a backdoor Roth?

The government wants to collect its taxes, one way or another. A backdoor Roth is not a way to escape taxes. The amount of taxes you owe on a backdoor Roth could range from none to a high tax bill. Most people who convert money to a Roth IRA via the back door need to learn what the pro-rata rule is and how it applies to their conversion.

The key questions are:

  • Are you converting money on which you have already taken a tax deduction?
  • Are you converting non-deductible contributions, money that you contributed after you paid taxes on it?
  • Are you converting your entire retirement portfolio to a Roth or keeping some money in Traditional IRAs, or SEP or SIMPLE IRAs? If you are keeping some money in Traditional IRAs, you will be subject to the pro-rata rule.

If you convert a Traditional IRA—money on which you have already received an income tax deduction—to a Roth IRA, you will owe taxes on the entire amount you convert. If you contribute $5,500 to a Traditional IRA and then convert the money to a Roth IRA, you will owe taxes on the $5,500, plus on whatever money it earns between the time you contributed to the Traditional IRA and when you converted it to a Roth IRA. If you have saved $500,000 in a Traditional IRA, and convert the entire $500,000 to a Roth, you will owe taxes on the $500,000.

On the other hand, you may have made non-deductible contributions to a Traditional IRA, money that you contributed after you had paid taxes on it. That can happen if you want to contribute to a Traditional IRA but you (or your spouse, if you’re married) have a 401(k) or similar plan at work and at are an income level that prevents you from deducting your Traditional IRA contribution. You can take that post-tax Traditional IRA money and convert it to a Roth IRA without another tax bill because you’ve paid the tax already.

Are you converting your entire retirement portfolio to a Roth, or keeping some money in Traditional IRAs, SEPs or SIMPLE IRAs?

If you convert some money to a Roth IRA and keep some money in other kinds of IRAs, you don’t owe taxes simply on the converted amount. Instead, you owe taxes based on the proportion of your IRA money overall that is after-tax and before tax.

To figure out how the pro-rata rule applies to you, calculate how much money in your IRA accounts is pre-tax and how much is after tax. Treat all of your IRAs like one big IRA for this purpose. Say you have a total of $100,000 in all of your accounts, and $10,000 of it is money you put in after taxes. You will owe taxes on 90% of the money you convert to a Roth.

How does this play out? Here are two examples, taken from Ed Slott’s The Definitive Guide to the ‘Back-Door Roth. Basically, if only a small proportion of your overall retirement assets are non-deductible, you will face a higher tax bill for your conversion.

Example 1

Jake has $100,000 in his traditional IRA, $10,000 of which is after-tax. Therefore, 10% ($10,000 / $100,000 = 10%) of his traditional IRA consists of after-tax money. If Jake wants to convert $20,000 of his Traditional IRA to a Roth IRA, $2,000 ($20,000 x 10% = $2,000) would be tax free. The remaining $18,000 ($20,000 – $18,000 = $2,000) would be taxable.

Example 2

Ann has $95,000 in her Traditional IRA, all of which is pre-tax. If Ann makes a $5,000 nondeductible (after-tax) contribution to a Traditional IRA, her total IRA balance will be $100,000, $5,000 of which will be after-tax. Thus, only 5% ($5,000 / $100,000 = 5%) of her Roth IRA conversion will be tax-free. If Ann converts $5,000 from her Traditional IRA to a Roth IRA after making her nondeductible contribution, just $250 would be tax free ($5,000 x 5%), while the remaining $4,750 ($5,000 – $250 = $4,750) would be taxable.

Will backdoor Roth IRAs always be available?

All tax policy—including rules set for Roth IRAs—is subject to change.  The continuing availability of backdoor Roth IRAs is definitely a question mark.

Roth IRAs were initially envisioned as a way for people to save for retirement, but still be able to access the money without penalties. It was thought that being able to withdraw money without penalties would attract younger savers.

At first, eligibility was limited. Whether you wanted to open a Roth IRA or convert an existing IRA into a Roth, you had to be beneath the income limit. Only people making less than $100,000 a year could convert their plans. Opening a Roth IRA is still limited to lower-income savers.

But the conversion cap was removed as older and higher-income investors asked for the benefit of tax-free withdrawals in retirement. Also, since there are no required minimum distributions (RMDs) for Roth IRAs during the lifetime of the account owner, the entire amount of money saved in a Roth can be passed down to your beneficiaries after your death. You can read more about the origins of Roth IRAs here.

The backdoor Roth remains a subject of debate over the long term so if you want to take advantage of this strategy, you may want to do so before policy changes.

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