What is a Backdoor Roth IRA?

When you open a Roth IRA, the IRS stipulates that you’re only able to contribute up until you hit an adjusted gross income (AGI) of $124,000 if you’re single (or married filing separately). If you’re married filing jointly, this increases to $196,000. 

Many people mistakenly feel that they’ve graduated out of being able to contribute to a Roth IRA. This is especially true as they near retirement, and have a notably increased annual income at the end of their career. 

However, even if you make over the IRS-specified limits, you still have the opportunity to leverage the tax benefits of a Roth IRA. The solution is a Backdoor Roth IRA, a legal way to sidestep the income limitations of a Roth IRA. Want to know more? Let’s dive in.

What is a Backdoor Roth IRA?

A backdoor Roth IRA is a conversion of a Traditional IRA to a Roth. People go through this conversion because the Roth IRA has numerous benefits. Primarily, your funds can grow tax-free in a Roth IRA because you pay the tax on contributions to the account up front. In other words, your Roth IRA is typically funded with income that’s already been taxed. Then, when you reach retirement, you’re able to withdraw the funds from your Roth IRA without paying additional taxes on the investment growth. And there is no Required Minimum Distribution on a Roth IRA.

Of course, you don’t completely avoid paying taxes on the funds you convert from a Traditional to a Roth IRA. Instead, you pay taxes on the amount of money you convert as a one-time taxable event. You pay taxes on the original contributions you made to your Traditional IRA and any gains earned. If your income limits your ability to contribute to a Roth IRA and you or your spouse have a retirement plan with your employer, it’s likely that you are unable to take a tax deduction for your IRA contribution.  You can still make a non-deductible contribution and convert it to a Roth IRA without paying additional taxes if done immediately.

This may still benefit you if you anticipate having a higher income as you near retirement than you currently do. You’ll be able to pay taxes on the funds now when your tax bracket is lower, rather than during retirement when it could be notably higher.

How Do You Set Up a Backdoor Roth IRA?

To set up a Backdoor Roth IRA, you start by setting up a Traditional IRA. This works best if you don’t have a funded IRA, SEPIRA or SIMPLE IRA to avoid the pro-ration of the funds. You may also need to set up a Roth IRA if you don’t already have one.  Fund the Traditional IRA for the current tax year with either deferred or after-tax funds. Conversions for the current taxable year must be done by April 15th of the following year, when taxes are due.  Form 8606 is used to 

Then, when you’re ready, you can either:

  1. Roll over a portion of your Traditional IRA to your Roth IRA.
  2. Fully convert the entirety of your Traditional IRA to your Roth IRA.

The distinction between using the Backdoor Roth IRA conversion and a Roth IRA conversion is that the Backdoor Roth addresses moving the current year’s contribution from the Traditional IRA to the Roth IRA.  For 2020, the contribution limits in 2020 ar $6,000 or $7,000 if you’re over 50. For a regular conversion there are no limits on amounts converted from your Traditional IRA to a Roth IRA. You will pay taxes on any deferred contributions at the time of conversion.  It’s very important to consider the tax consequences of your actions, so include your tax advisor in your plans before undertaking to convert your Traditional IRA to a Roth IRA.

Know the Rules

As streamlined as a Backdoor Roth IRA may seem, there are a few rules to keep in mind before taking the leap. 

  1. Pro-Rata. All IRA transfers are completed “pro-rata”. This means that, if you have multiple Traditional IRAs that you’ve funded with both pre-tax and post-tax money, the IRS looks at all of your accounts. They determine what percentage of funds are taxable, and that percentage of your conversion is taxed accordingly. It doesn’t matter if you’re only converting funds that have already been taxed, the IRS exclusively looks at the pro-rata percentage to determine what you owe. 
  2. Conversion v. Contribution. When you convert money into a Roth IRA, that money is converted not contributed. With that, the converted money falls under the 5-year holding period, which means you can’t touch the money you’ve converted without notable penalties for at least 5 years if you are younger than 59 ½.  If you have held your Roth IRA for at least 5 years, special rules may apply for withdrawals. 

Considering a Backdoor Roth IRA?

Although a Backdoor Roth IRA may be a convenient savings solution to trim back taxes you’ll owe during retirement, it’s important to get a professional opinion moving forward. A fee-only financial planner can help you uncover whether a Backdoor Roth IRA will have the benefits you need to make the conversion worthwhile. Have questions? Contact us today. We’d love to talk with you about your retirement savings strategy.

Wood Smith Advisors, a woman-owned Registered Investment Advisor (RIA), is a fee-only financial services firm that partners with its clients to simplify their financial lives. We focus on women, entrepreneurs, and individuals with complex financial situations, providing objective and competent advice, education and services to help them develop and build their businesses and reach their financial goals. We can be reached by clicking here.

"Finance Made Simple" blog posts are intended for educational purposes and not for specific advice. Each person’s situation is different. Consult your financial advisor for advice relating to topics discussed.

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