One of the best investment options when you’re planning your retirement is a Roth IRA.
I discussed this in detail in my previous guide to Roth IRA, but to recap, it is a specific type of individual retirement account (IRA) that allows you to not only grow your investments tax-free but also to take tax-free withdrawals of your contributions later, subject to certain conditions.
The key features of a Roth IRA are :
- Only the income you earn (also known as taxable income) can be contributed towards a Roth IRA.
- You can make tax-free withdrawals on your earnings after a five-year holding period, upon meeting certain conditions (reaching age 59 ½, having a disability, or using the funds to buy your first home).
- There is a maximum annual contribution limit of $6,000 ($7,000 if you’re older than 50).
- Your income has to be lower than a certain amount in order to be eligible to contribute towards a Roth IRA. The amount you can contribute diminishes as your income rises, and beyond a certain limit, you cannot contribute to this type of account at all.
Now pay special attention to that final point, because this is what I’m going to be talking about in this article.
Why a backdoor Roth IRA?
The current income limits for a Roth IRA are a modified adjusted gross income of:
- $196,000 for a married couple filing jointly
- $124,000 for an individual
The higher you earn above this threshold, the less you are allowed to contribute to a Roth IRA, until finally you are no longer eligible for a Roth IRA.
Now for many who earn above the income limit, going by the regular rules and opening a Roth account is not possible, since the IRS begins to reduce the amount you can contribute as your income rises, until finally, you cannot participate at all. While the limits are adjusted every year or so on account of inflation, the vast majority of higher-income taxpayers would be excluded from contributing to a Roth IRA.
This is where a backdoor Roth IRA comes into play.
A backdoor Roth IRA is nothing but a legally sanctioned way for high income earners to avail themselves of the benefits of a Roth IRA, through some smart paperwork. It sounds a little dubious, but let me assure you that this is an IRS-sanctioned method that is really quite common.
How to set up a backdoor Roth IRA
Simply put, you have to put money in a traditional IRA, convert this account to a Roth IRA, pay some taxes and voila! Though you may have not been eligible to contribute to a Roth IRA, you’ve gone in through “the back door”, so to speak, and can now enjoy the benefit of growing your money tax-free – something you will really appreciate when it’s time to withdraw that money when you retire.
Let’s delve into this in a little more detail:
- Open a traditional IRA account:
If you don’t already have an IRA account, you should open one and fund it. Depending on how hands-on you plan to be with your investment, you can choose from a wide variety of IRAs – here are NerdWallet’s top picks for IRAs in 2020.
- Pay taxes on your contributions and earnings :
A Roth IRA can only be funded with post-tax dollars. So if you have previously deducted any traditional IRA contributions and then convert your traditional IRA into a backdoor Roth IRA, you will need to return that tax deduction. When you’re next filing your tax return, you will need to pay income tax on the money you converted into a Roth IRA. I’ll get into how this amount should be determined a little later – check my note on the pro-rata rule.
- Convert your account to a Roth IRA :
Assuming you don’t already have a Roth IRA, you will now have to open a new account. Your IRA administrator should be able to guide you in this matter – I chose to open my account at TRowePrice, but there are several great companies you can choose from.
How does the actual conversion take place? You have three options :
- An indirect rollover, in which you receive the money from your traditional IRA and deposit it into your Roth IRA within 60 days
- Direct rollover (trustee to trustee), in which you entrust the financial institution that currently holds your traditional IRA assets with transferring the amount to the financial institution where you opened your Roth IRA
- Same trustee transfer, in case your traditional and Roth IRAs are held at the same financial institution.
Does a backdoor Roth IRA have any tax implications?
While a backdoor Roth IRA might provide you with future tax savings, keep in mind that this is not a tax dodge. You will still need to pay taxes on any money in your traditional IRA that has not already been taxed. You will also have to pay taxes on any amount earned between the time you contributed to your traditional IRA and converted to a Roth IRA.
The fact that the funds you convert to a Roth IRA are considered as “income” mean that you risk being pushed into a higher tax bracket. The saving grace is that you don’t have to pay full taxes on this money ; you will be taxed on a pro rata basis.
The Pro Rata rule:
When determining how much tax you’ll need to pay when converting your traditional to a Roth IRA, the IRS will consider a combined view all of your traditional IRA accounts (if you hold any). The ratio of pre-tax vs. post-tax money held in all your IRAs will determine what percentage of the money you convert to a Roth IRA will be taxed. Let me explain that a little further.
- Calculate the total balance of your IRAs, excluding any Roth IRA balances. Let us assume that this is $100,000.
- Calculate the total amount of all post-tax dollars in all of your IRAs. These are either non-deductible contributions made to your IRA, or rollovers of post-tax dollars from a company plan. Let us assume that this is $20,000.
- Calculate the percentage of your post-tax dollars by dividing the total amount of post-tax dollars by your total IRA balance ($20,000 / $100,000 = 20%)
- Determine the taxable amount of the contribution towards your Roth IRA by multiplying the converted amount into the earlier percentage we calculated. For example, if you convert $10,000 to a Roth IRA, then $2,000 (20% of $10,000) is tax-free, whereas the remainder of $8,000 will be taxed at ordinary rates.
I’ve heard a lot of people mention the risk of being heavily taxed due to this pro-rata rule as one of the biggest deterrents to opening a backdoor Roth IRA. However, there is a way around this, which is to rollover your pre-tax assets into a current employer-sponsored plan, such as a 401(k), which would prevent these assets from being included in the conversion. Let’s dig a little deeper here.
Converting to a Roth IRA from a 401(k)
Rolling your 401(k) into a Roth IRA is tricky, since employer-sponsored plans are typically funded with pre-tax dollars and Roth IRAs are funded with post-tax dollars. First, you will need to rollover the funds to a traditional IRA and then convert that traditional IRA to a Roth IRA.
The biggest caveat here is that you will have to pay taxes at ordinary rates when you convert to the Roth IRA, since (a) you received tax deductions for your contributions to the 401(k), and (b) you did not have to pay taxes in order to rollover to a traditional IRA.
Note, that in case you contributed more than the deductible amount to your 401(k), you might be able to avoid paying immediate taxes by allocating the post-tax funds in your retirement plan to a Roth IRA and the pre-tax funds to a traditional IRA.
It’s a tricky process, and one I would not recommend you try without getting some solid advice from an experienced finance professional. The benefit of this approach, however, is that you can enjoy tax free deductions from your Roth IRA fund upon retirement. It is a winning long-term strategy, if you have the capacity to absorb the immediate taxes you’ll need to pay.
Is a backdoor Roth IRA for you?
As with any investment option, the choice depends on your situation and approach to financial planning.
|Pros : |
It allows you to withdraw contributions at any time, for any reason, tax-free.
It allows you to reduce the amount of taxes you pay in retirement.
It allows your investment earnings to grow tax-free.
It shields you from paying IRS mandated minimum distributions that are required from a traditional IRA
You may have a hefty tax bill to pay upfront upon converting to a Roth IRA.
It is not a very liquid option if you need the cash in the immediate future; learn more about the Roth Five Year Rule here.
You may not reap the benefits if you expect the tax rate to reduce in the future.