You’ve probably heard of a retirement planning strategy known to many as the “Back-Door Roth.” But how is it different than the traditional IRA and what are the benefits? When the income limits on Roth conversions were removed in 2010, higher-income individuals who are not eligible to make a Roth IRA contribution were allowed to make an indirect “backdoor Roth contribution” instead, by simply contributing to a non-deductible IRA (which can always be done regardless of income) and converting it shortly thereafter. This makes a Backdoor Roth IRA a great saving and earning vehicle that allows you to circumvent the income limits on a Roth IRA by converting a traditional IRA to a Roth IRA.
Who should you consider the Backdoor Roth?
To be able to take advantage of the Backdoor Roth IRA, your income must be “too high” for contributing to a Roth IRA. You can check this against the publically published income limits by the IRS every year.
Higher earners like physicians need to be aware of the income limit rules that make the investor ineligible for investing in a Roth IRA. The income limits for 2016 is as follows:
For single filers – $132,000
For married filing jointly – $194,000
To get around the eligibility limits on a Roth IRA, the investor can contribute to a traditional IRA (regardless of income), and then convert the traditional IRA to a Roth IRA without being subject to the income eligibility limits. This will allow you to benefit from the tax savings that the Roth IRA provides.
This may sound illegal, but it’s not. In 2010, the US government dropped the income limits attached to the IRA conversion, which created this Roth IRA loophole, otherwise known as Backdoor Roth IRA.
How to Set Up a Backdoor Roth IRA
Although the backdoor Roth IRA is perfectly legal, there are certain steps that must be taken in order not to run afoul of the law. Also, if your annual income is below the 2016 eligibility limit listed above, stop reading because you can continue contributing to a Roth IRA.
The steps to using a Backdoor Roth IRA are as follows:
Put some money in a Traditional IRA account: If you don’t already have a traditional IRA account, you’ll need to create one and fund it.
Convert Your Traditional IRA to a Roth IRA: Consult with the administrator of your traditional IRA for the instructions and paperwork required for the conversion.
Pay the Taxes on any pre-tax contributions if you had an existing Traditional IRA: Since only after-tax dollars can fund your backdoor Roth IRA, if you are converting an existing Traditional IRA that has been funded with pre-tax dollars, you are required to pay the taxes on those contributions just like anyone else who invests in a Roth IRA.
Pay the taxes on any gains that were in your traditional IRA before the conversion: If your pre-existing traditional IRA balance includes investment gains, you are required to pay the taxes on those gains when you convert it to a Roth IRA and report this on next federal tax return.
Tax Advantages Of the Backdoor Roth IRA
The biggest advantage of the Roth IRA is that once it’s funded with after-tax dollars, it’s never taxed again. When you withdraw your funds, neither the contributions nor the earnings are taxable. This means that if you experience financial hardship, you can withdraw some of your contributions tax-free. To withdraw earnings, however, the account holder must be at least age 59 ½ and the account must have been opened for at least 5 years. However, even with this rule, there are still ways to make qualified withdrawals if you don’t meet the minimum age and account limit.
Pros and Cons of the Backdoor Roth IRA
Just like any other investment, there are always pros and cons that should be considered before taking action.
The backdoor Roth IRA rules allow high-earners to legally circumvent the income eligibility requirements and take advantage of significant tax advantages.
Withdrawals that are tax free are worth considerably more to people in a high tax bracket than they would to people in a lower tax bracket.
Opening an account is relatively easy and can be accomplished on your own or with a little help from your account administrator.
The backdoor Roth IRA eliminates your need to re-characterize your direct Roth contributions in the event of your income exceeding the limit in your Roth IRA.
Although the steps to creating your backdoor strategy are basic and easy to follow, errors are not uncommon and can result in administrative penalties.
You are required to pay taxes on your contributions to an existing IRA and any gains when you convert to a Roth IRA.
In the event of the Federal government closing the backdoor (loophole), existing accounts may be affected.
Backdoor Roth IRA Errors To Avoid
The Pro-Rata Rule
When an investor owns other Traditional IRA assets that are yet to be taxed, the taxes you’ll owe on the conversion will depend on the ratio of IRA assets that have been taxed compared to those that haven’t. If the old non-taxed assets exceed the new IRA that consists of taxed assets, most of the new IRA assets will become taxable when converted to a Roth IRA.
Recharacterize When Needed
If you find that your backdoor strategy proves regrettable because you had other non-taxed IRA assets, which means your backdoor IRA comes with higher tax liability than you expected, you have the option to recharacterize the conversion. This allows you to switch the newly converted Roth assets back to Traditional IRA status, thereby undoing the conversion and the resulting tax liability.
Waiting to Take Action
Despite the President’s attempt to remove the loophole that created the backdoor conversion in 2016, it is likely that more attempts will follow. Essentially, this means it’s a matter of time before specific legislation is introduced that may affect the backdoor.
Although you can create and plan your backdoor Roth IRA strategy on your own, if you’re like most people, you may want to confirm that you’ve set it up correctly and paid any outstanding taxes that may have been required. It’s recommended you get in touch with a trusted advisor to walk you through the process and double-check everything.