Understanding the Backdoor ROTH IRA

 

A ROTH IRA is a special individual retirement account that you can fund with money you’ve already been taxed on. Subsequently, the contributions that you put on your ROTH IRA account will grow, tax-free, and all your future withdrawals from it upon retirement may be tax-free as long as they are considered qualified.

Understanding a Back door Roth IRA

 

ROTH IRAs are generally advantageous because they do not contain a requirement for minimum distributions.  Traditional IRAs require you to begin making required minimum distributions (RMDs) from your account by April 1 of the calendar year following the year you reach age 70. Because the contributions are pre-taxed, your retirement savings grow tax-free.  You pay taxes on the investment gain only when you make withdrawals in retirement.

However, if you are a high-income earner, there are strict income caps that have been imposed by the IRS that make it prohibitive for high grossing individuals to make a contribution to a ROTH IRA.  That said, there is still a “backdoor” through which permits you to make contributions to a ROTH IRA even if you exceed the IRS income thresholds. This is called a backdoor ROTH IRA conversion.

What is a Backdoor ROTH IRA?

A backdoor ROTH IRA allows you to enjoy tax advantages and flexibility of a ROTH IRA even if you are a high-income earner who exceeds the IRS income caps for a ROTH IRA contribution.

This is possible because, under the current regulations which were passed in 2010, virtually anyone is allowed to convert their Traditional IRA contributions into a ROTH IRA, no matter their incomes. The current regulations also allow you to convert as much money as possible from existing traditional IRA accounts into a ROTH IRA account. If your yearly traditional IRA contribution is over the limit, you are allowed to roll over the larger amount into your ROTH IRA account.

Using the Backdoor ROTH IRA you first make your contributions to your traditional IRA, then sell your shares and move the money into your ROTH IRA account. Alternatively, it is possible to roll over an entire traditional IRA account into a ROTH IRA. It is generally a fairly complex process and it is advisable to talk to your financial advisor for assistance in executing the rollover.

The Backdoor ROTH IRA requires you to pay taxes on any untaxed contribution in your traditional IRA account. The rollover into a ROTH IRA can carry some tax risks. Since the funds that have been converted into the ROTH IRA account are counted as an income, the conversion could put you into a higher tax bracket resulting in higher tax obligations. You can minimize the tax burden by executing the conversion in a year when you might have an unusually low income.

Is a Backdoor ROTH IRA Suited for You?

There are several advantages of converting your money from a Traditional IRA into a ROTH IRA. For one, you pay the taxes when making a contribution and can, therefore, enjoy tax-free withdrawals when you reach retirement as long as you adhere to the stipulated requirements. This not only insulates you from future tax increases on IRA contributions, you also get to enjoy the compounding effect on savings as your money grows tax-free.

With ROTH IRA, your money also gets to grow for longer because you don’t have to grapple with the required minimum distributions when you hit a certain age. With a traditional IRA, you are required to take minimum distributions once you reach the age of 70 ½ even if you don’t necessarily need the money.

A ROTH IRA also allows you to leave your descendants a tax-free inheritance. While the beneficiaries of your ROTH IRA still have to take annual required minimum distributions, they will not pay any federal taxes on their withdrawals.

Under the current IRS regulations for 2018, you will not qualify for a ROTH IRA if your modified adjusted gross income is $135,000 for a single person or $199,000 for a married couple that is filing jointly. So if your income lies outside these IRS caps, you may want to consider a Backdoor ROTH IRA.

You can also use the Backdoor ROTH IRA to bypass ROTH IRA contribution limits set by the IRS. Under current regulations, you can only contribute $5,500 or $6,500 per year if you are over 50 to either or both traditional and ROTH IRA accounts. If you are a high networth individual and wishes to put more money into your retirement accounts, you can use the backdoor ROTH IRA to bypass these limits.

The Tax Implications of a Backdoor ROTH IRA

The ROTH IRA is not a tax avoidance strategy. Your backdoor ROTH IRA may still be liable to taxes if you will be transferring money from a tax-deferred account such as from a traditional IRA.  So you may still owe taxes on some of the contributions that you have rolled over into your ROTH IRA account.

To understand the tax implications of a backdoor ROTH IRA conversion, factor in the following:

  • Whether you are converting money on which a tax-deduction has already been taken.
  • Whether you are rolling over non-deductible contributions: these are contributions that you made after-tax.
  • Whether you are converting an entire retirement portfolio to a ROTH IRA or keeping some of the cash in other IRA accounts such as a Traditional IRA.

When rolling over the amounts from a traditional IRA, you will owe taxes on the whole amount converted. For example, when converting $5000 from a traditional IRA into a ROTH IRA through the Backdoor, you are going to pay taxes on the entire $5000 plus on any accrued interest between the time you made the contribution and the time you made the conversion.

However, if you roll over a non-deductible Traditional IRA, that is money on which you have already paid taxes, you can execute the conversion without any tax bill.

If you are rolling over some money into a ROTH IRA and keeping some money in other IRA accounts, the amount of taxes that you will owe in all accounts will depend on the proportion of the contributions that is non-deductible. IRS will only tax the contributions on which taxes have not been paid. To figure out the tax implications of a backdoor ROTH IRA conversion, you need to calculate the proportion of your income that is after-tax and the amount that is pre-tax. You will only pay taxes on your pre-tax income.

The Future of Backdoor ROTH IRA

The backdoor ROTH IRA came into effect in 2010 when Congress eliminated the income limits on the ROTH IRA conversions. This enabled many high income earners to convert their Traditional IRA into a ROTH IRA. A 2016 budget proposal by the Obama Administration was geared at reversing the 2010 Congress decision which could have effectively eliminated the Backdoor ROTH IRA.

The current GOP tax reform proposal does not do away with the income limits on ROTH IRA conversions so the backdoor conversions will still continue. However, it does take away the freedom to undo a ROTH IRA conversion. Under the new tax reform proposals, you will not be able to reverse a conversion and this may end up making them less attractive if the bill passes with the provision.

For more information on traditional and Backdoor ROTH IRAs, contact us today.

The Roth IRA offers tax deferral on any earnings in the account.  Withdrawals from the account may be tax free, as long as they are considered qualified.

Limitations and restrictions may apply.  Withdrawals prior to age 59 or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax.  Future tax laws can change at any time and may impact the benefits of Roth IRAs.  Their tax treatment may change.  Traditional IRA account owners should consider the tax ramifications, age and income restrictions in regards to executing a conversion from a Traditional IRA to a ROTH IRA.  The converted amount is generally subject to income taxation.  When taking withdrawals from an IRA before age 59, you may have to pay ordinary income tax plus a 10% federal penalty tax.  All investing is subject to risk, including the possible loss of the money you invest.