Money Girl explains a tricky tax strategy that makes anyone eligible for a Roth IRA.
If you’re a regular Money Girl reader or listener, you’ve heard me talk about the fantastic tax benefits of a Roth IRA. Problem is, the door to a Roth IRA gets slammed in your face if you make too much money.
However, if you can’t get in the front door, sometimes the backdoor is wide open! In this episode, you’ll learn about an interesting strategy that high-earners can use to have a Roth IRA, without breaking the rules.
What Is a Roth IRA?
A Roth IRA is a special type of retirement account that’s never taxed after you make contributions. Instead of getting a tax deduction on money you put in the account, like you do with a traditional IRA, a Roth gives you a tax break on money withdrawn from the account.
But, as I mentioned, not everyone can have one. There are limits placed on individual and joint income, which make you ineligible for Roth contributions. Read or listen to my episode, Your Guide to the Roth IRA, Part 1, to find out if you qualify for a Roth IRA.
What Is a Backdoor Roth IRA?
The tricky strategy that we’ll cover today is called a backdoor Roth IRA. It allows anyone, regardless of income, to move money from a traditional IRA to a Roth IRA. Unlike a Roth, there’s no income limit for contributing to a traditional IRA.
Most traditional IRAs are deductible, which means you make pre-tax contributions. When you convert these contributions to a Roth IRA, the music stops playing and the money is fully taxable. Since that could be a big tax liability, most people don’t even consider it.
However, you can also have contributions in a traditional IRA that are non-deductible. That means you make them after paying tax and never get to claim a tax deduction for them.
What’s interesting is that the IRS allows you to convert non-deductible IRA contributions into a Roth IRA. There’s no tax due, except on growth in the account that you earn between the time of contribution and conversion.
If you hold money in a traditional IRA for a short period of time only, the growth and resulting tax should be very small. So, this “backdoor” contribution is about the same as making a contribution to a Roth IRA, even if you earn too much to qualify for a Roth.
Related Content: What Is the Difference Between a Traditional and Roth IRA?
Problems With a Backdoor Roth IRA
Though sneaking into a backdoor Roth IRA sounds perfect, it doesn’t always work as planned. If you already have pre-tax money in a traditional IRA, it presents a problem. For instance, you may have rolled over a 401(k) from an old employer into an IRA or contributed to a traditional IRA on your own.
Here’s the catch: When you do a Roth conversion, tax must be prorated over all of your IRAs. You can’t convert just the non-deductible money and forget about pre-tax amounts.
For example, let’s say you have $5,000 in a non-deductible IRA that you want to convert into a Roth IRA. But you also have $15,000 in a pre-tax, deductible IRA.
Since you have a total of $20,000 in IRAs, the $5,000 non-deductible portion is 25% ($5,000 / $20,000 = 0.25 or 25%) and the taxable portion is 75% ($15,000 / $20,000 = 0.75 or 75%).
Therefore, you’d have to pay the same ratio of tax on the conversion. So, 75% of $5,000, or $3,750, would be subject to tax. But if you only had $5,000 of non-deductible money, then you could convert the full amount into a Roth IRA with no tax due.
The point to remember is that if you have a lot of money in a traditional, pre-tax IRA, then doing a backdoor Roth IRA won’t help you avoid tax. The IRS requires you to lump all your IRAs together when you make a distribution and doesn’t allow you to cherry-pick one account to convert.
Solution for Doing a Backdoor Roth IRA
However, there is a possible solution if you really want to do a backdoor Roth IRA and you have a retirement plan at work. You could remove your pre-tax IRA money from the equation by rolling it over into your 401(k) or 403(b). That would leave you with just non-deductible, after-tax IRA money to convert to a Roth.
This strategy only works if your workplace plan allows incoming IRA rollovers, and most do. Plus, you need to be very happy with the investment choices and fees in the plan because you don’t have as much control over a 401(k) as you do with an IRA.
If you’re self-employed, you could set up a solo 401(k) that allows roll-ins and move your pre-tax IRA money into that plan.
Contribution Limits for a Backdoor Roth IRA
To sum up, you get a backdoor Roth IRA by funding a non-deductible traditional IRA first and then converting it to a Roth. High earners who do this won’t qualify to make new contributions to a Roth IRA because the annual income limits still apply.
However, once your money is converted to a Roth it grows tax-free (as opposed to tax-deferred in a traditional IRA) and that could save you a bundle in taxes.
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