Roth IRAs can be a great way to save for your retirement. Contributions are made with after-tax dollars, there is no immediate tax benefit. The money in the account grows tax-free until withdrawn in retirement. Assuming certain rules are followed, you can withdraw funds in retirement completely tax-free. In addition, Roth IRAs are not subject to required minimum distributions, making them a great tool for estate planning as well.
(Note that IRA contributions are limited to $6,000 with an additional $1,000 available for those who are age 50 or over at any point during the year.)
What is a Backdoor Roth IRA?
A backdoor Roth is a way around the income ceiling for contributing to a Roth IRA account directly. Under this arrangement, you make an after-tax contribution to a traditional IRA account and then convert some or all of the money in the traditional account to a Roth IRA.
Roth IRA contributions are limited to those under certain income levels. For the 2019 tax year these income levels are:
For single filers:
- If your modified adjusted gross income* (MAGI) is less than $122,000 you can contribute up to the full amount allowed.
- If your MAGI is over $122,000 but less than $137,000 then the amount is phased out proportionally.
- No Roth contributions are allowed if your MAGI is over $137,000.
For married filing jointly:
- If your MAGI is less than $193,000 you can contribute up to the full amount allowed.
- If your MAGI is over $103,000 but less than $203,000 then the amount is phased out proportionally. * No Roth contributions are allowed if your MAGI is over $203,000.
Modified adjusted gross income is defined as your adjusted gross income plus the add-back of certain deductions such as student loan interest, self-employment tax and others. (Please consult a qualified tax or financial advisor to help you calculate this figure.)
A backdoor Roth contribution comes into play for those who wish to make a Roth IRA contribution, but whose income is too high to qualify.
Using the backdoor
If your income is too high for you to make a Roth IRA contribution, or to go in the “front door” so-to-speak, then you might need to use the “back door” in order to contribute to a Roth IRA.
A backdoor Roth contribution starts with an after-tax contribution to a traditional IRA account.
Backdoor Roth IRA conversion
A backdoor Roth conversion works like this. You make an after-tax contribution to a traditional IRA account. You then do a conversion of this amount or some portion of the amount in the IRA account to a Roth IRA, hence the term “backdoor.” Sounds simple, but there are several rules you need to consider.
Backdoor Roth IRA conversion rules
Before moving forward with a backdoor Roth, there are some rules you’ll want to understand:
- Money converted from a traditional IRA account to a Roth is taxable at your ordinary income tax rate. The exception to this is the amount of your after-tax contributions. Any money that was contributed on a pre-tax basis would be subject to taxes, as would any earnings on your contributions regardless of whether or not they a pre-tax or after-tax.
- If you have money from both pre and after-tax contributions in traditional IRA accounts, the tax treatment of the conversion will reflect the proportion of after-tax money to pre-tax money and earnings across all traditional IRA accounts.
If you have $100,000 in traditional IRA accounts and $80,000 of that money is attributable to either earnings on the account(s) or pre-tax contributions, 80% of your conversion for that year will be taxable.
The ideal scenario would be to contribute the full $6,000 (assuming you are under 50). And then leave the money in cash or a low-earning account and make the conversion to a Roth as soon as possible. You will pay zero taxes or a very minimal amount if there were some earnings in the account upon conversion.
Even if you need to pay taxes on the conversion, it will be at a relatively low rate. Individual tax rates were reduced across the board for most taxpayers under the tax reform legislation passed at the end of 2017. These lower rates are scheduled to expire after the 2025 tax year, so the backdoor Roth might still be attractive for those who earn too much to contribute directly to a Roth IRA.
The right answer might also be to convert some IRA money to a Roth and leave some in traditional account to hedge your bets against the unknown future direction of tax rates.
No conversion do-overs
One change arising from tax reform is that you can no longer do a Roth conversion “recharacterization.” This allowed you to reverse your Roth conversion prior to the extended tax filing date each year, October 15 . An investor might have used this option if the market had declined since the time that they had made the conversion, driving the value of the Roth account lower.
Don’t forget your 401(k)
Another way around the Roth IRA income-based contribution limits might be your company’s 401(k) plan. For plans that offer a Roth option you can contribute up to the limits which are $19,000 with an additional $6,000 catch-up contribution for those 50 and over in 2019. There are no income ceilings with a Roth 401(k). Note that any employer matching contributions will be made to a traditional account as per the rules in place.
For those who can’t contribute to a Roth IRA through the front door, a backdoor Roth IRA and conversion might be the right tool.