Knock, Knock! It’s the "Backdoor" Roth IRA
In my year end planning with clients there is a topic that is discussed often, IRA contributions. Should they contribute to their Traditional IRA, should they contribute to their Roth IRA, or CAN they contribute to their Roth IRA?
During these discussions it is not uncommon for clients to bring up one concept they have heard about but are not really sure what it is, the ‘Backdoor Roth IRA.’ I have had people mention this to me and refer to it as if it is an account structure. They say ‘Chris, I need to open a Backdoor Roth IRA,’ and they are surprised when I explain to them that this is not an account, but a strategy for adding funds to a Roth IRA.
In this blog I want to help you understand:
- What a backdoor Roth IRA actually is
- How it works
- And, an important rule to be aware in completing one
What is a backdoor Roth IRA?
With the tax-free growth feature of a Roth IRA, it is an appealing long-term strategy for many clients. Because of the tax benefits, the IRS has placed a limit on the amount of income you can earn and still be able to make an annual contribution to a Roth IRA.
As of 2020, for a single tax filer, you cannot contribute to a Roth IRA if you make over $139,000/year. For a married couple filing jointly the limit is $206,000 of combined income. These limits mean you cannot dedicate your contribution directly to a Roth IRA, but you can do so indirectly. In short, you contribute through the backdoor!
Because there is no income limit on Roth IRA conversions, you can make a nondeductible contribution to a Traditional IRA and convert that contribution to your Roth IRA. Even though it was not directly contributed to the Roth IRA, this method allows you to still add new funds to the account and use the tax-free growth potential to your advantage long term.
How it Works
To begin this process, you need to first open a Traditional IRA. Then, make a nondeductible contribution to that IRA.
The nondeductible status of the IRA is due to your income being too high and your eligibility to be covered by an employer sponsored retirement plan, like a 401(k). In these cases, you lose the tax deductibility of the contributions, but those contributions come back out of the account tax free in retirement. The earnings, on the other hand, are taxed as regular income when withdrawn.
If you are asking “What if I am eligible for deductible IRA contributions?” that means you most likely fall under the provisions that allow you to make a regular Roth IRA contribution. In that case, you can go ahead and make the regular contribution to the Roth IRA and avoid this process.
This treatment of the earnings on the nondeductible IRA are why it is appealing to take the next step and complete the Backdoor Roth IRA process. By taking the final step and converting to a Roth IRA you now gain the potential for these earnings to also grow tax-free and be withdrawn tax-free in retirement.
One Important Rule!
An important rule to remember in the process is called the IRA Aggregation Rule under IRC Section 408 (c)(2). Simply put, this rule states that you must add all the IRAs you own together and view them as one IRA. You must take an equal percentage of all IRAs (remember that qualified employer retirement plans, such as a 401(k), are not part of this) when making a Roth IRA conversion.
Assume you have $100,000 in Traditional IRA accounts. You want to contribute $6,000 as a nondeductible contribution to an IRA and convert this to a Roth using the backdoor strategy. You need to determine what percentage is going to be tax-free and what is taxable. Here is how this works:
- $100,000 in existing IRA Accounts
- $6,000 Contribution to convert to Roth IRA
- Total in IRAs under the rule is: $100,000 + $6,000 = $106,000
- So, $6,000 Contribution/$106,000 Total of IRAs = 66% of the conversion that is tax-free.
- Therefore, 66% of the of the converted $6,000, which equals $340, is tax-free.
- The remaining 34% of the converted amount, which equals $5,660, will be taxable.
This all means that $340 (5.66%) of the $6,000 converted is tax-free and the remaining $5,660 will be taxable. So, you would end up with a Roth IRA of $6,000, and $100,000 in Traditional IRAs with $5,660 of related after-tax contributions.
The key takeaway is that because of the IRA Aggregation Rule, if you are going to take advantage of the backdoor Roth IRA strategy it helps to reduce your IRA amounts. One of the ways to do this is to possibly add your IRA accounts to your existing employer sponsored retirement plans, like your 401(k), since these are not part of the Aggregation Rule.
This rule can seem very complicated, and you may not be sure IF this is strategy fits in your financial plan or HOW this strategy fits in your financial plan.
To find out more about this strategy and if it is something that fits into your financial planning, give us a call at 412-357-2002 and we can help to educate and empower you to make this and many other informed financial decisions.
This is meant for educational purposes only. It should not be considered investment advice, nor does it constitute a recommendation to take a particular course of action. You should carefully consider all of your available investment options prior to making any financial decisions. Waddell & Reed does not offer tax advice. Please contact your financial and tax advisors regarding your personal situation. Withdrawal of earnings from a Roth IRA before age 59 ½ and before the account is 5 years old may be subject to taxes and a 10% penalty.