A Roth IRA can be a great savings vehicle for retirement. Once money is in a Roth IRA, it grows tax-free and distributions from the account are not taxed. The tricky part is getting money into a Roth IRA. There are two ways to do this – by making annual contributions or by doing a Roth conversion.
The annual allowed contribution amount to a Roth IRA is $6,000 ($7,000 if you are 50 and older). But not everyone can contribute to a Roth IRA. You can only contribute to a Roth IRA to the extent you have earned income. On the other hand, you can’t have too much income. There are income limits when contributing to a Roth IRA. (A single tax filer’s Modified Adjusted Gross Income (MAGI) must be under $140,000 and, if filing married jointly, MAGI must be under $208,000.)
A Roth conversion is a transfer of assets from a traditional, SEP or SIMPLE IRA into a Roth IRA. There are no income or contribution limits when doing a Roth conversion. However, any amount that is converted from an IRA to a Roth IRA is considered taxable income on your tax return. Since this is a taxable event, it is best to do a Roth conversion when you are in a low tax bracket.
If you are in a high tax bracket, a backdoor Roth conversion strategy can make sense. With a backdoor Roth conversion, a non-deductible contribution is made to a traditional IRA and then converted (or transferred) to a Roth IRA. This is a legal way to get around the income limits with potentially less tax consequences. Please click here to see if you are eligible to make a backdoor Roth IRA conversion.
How to do a backdoor Roth conversion.
- Open a traditional IRA and make a non-deductible contribution to it.
- Convert the traditional IRA to a Roth IRA by transferring the money in the IRA to the Roth conversion account.
- This can be repeated annually.
Some important caveats
There are two situations that can cause a back-door conversion to be partially or fully taxable:
Issue #1 – You have pre-tax IRA money
IRA distributions (including Roth conversions) are subject to “pro-rata” rules which determine how much of the distribution is taxable. To determine how much of an IRA distribution is taxable, first, total the after-tax dollars in all your traditional IRAs. Then, divide this amount by the December 31st balance of all your traditional IRAs combined. Next, multiply that percentage by the amount of all traditional IRA distributions for the year. The calculated amount represents the tax-free portion, and the remaining IRA distribution is taxable.
Let’s say you do a $6,000 backdoor Roth conversion. As of December 31st, the combined value of all your IRAs (pre-tax and after-tax) equals $50,000. If $10,000 is in after-tax dollars, then 20% ($10,000 divided by $50,000) of your backdoor Roth conversion is tax-free. 80% or $4,800 of the Roth conversion is considered a taxable distribution from your IRA.
If you have pre-tax IRA money that originated from a qualified retirement plan (an IRA rollover), see if your current retirement plan accepts rollovers from previous qualified retirement plans and roll the money into the current plan. This would eliminate pre-tax IRA accounts that would be subject to the “pro-rata” rules.
Issue #2 – The after-tax IRA contributions have grown
Any earnings on money in a non-deductible IRA are taxable when converted to a Roth IRA.
After the non-deductible IRA contribution is made, either keep the contribution in cash or immediately move the contribution into a Roth IRA, reducing the amount of possible earnings in the non-deductible IRA account.
Also note that to avoid taxes and penalties on the earnings, withdrawals should be taken after a five-year holding period and after age 59 ½. You can avoid the penalties if the money is used for certain expenses such as first-time home purchases, qualified education expenses and birth or adoption expenses. There would not be an exception on the taxation on earnings.
Each Roth IRA conversion is subject to the five-year rule. If you make a conversion in May 2018, you must wait until January 1, 2023 to withdraw funds from the conversion. If you complete another Roth conversion in 2019, a new five-year clock starts for that transaction. If you do not wait the requisite five-year period from conversion to withdrawal, you may have to pay a 10% penalty on the earnings.
Who can benefit from a backdoor Roth?
- High earners who do not qualify to contribute to a Roth IRA under current Roth IRA rules
Who may not benefit from a backdoor Roth?
- Those who are eligible to contribute directly to a Roth IRA
- Those who expect to use the converted funds within five years.
- Those who have other traditional IRAs, SEP IRAs or SIMPLE IRAs. The pro-rata rules can complicate matters to the point that tax consequences outweigh the benefits.
If you are a high-income earner who has already maxed out your other retirement saving options, are willing to leave the money in the Roth IRA for at least five years and do not have other pre-tax IRA assets, backdoor Roth conversions should be considered when planning for your retirement. If you are able to deploy this strategy consistently over a number of years, you will have a sizable tax-free account to draw from in retirement. Contact us today if you would like to develop a financial plan that incorporates this strategy.