What’s a Backdoor Roth IRA?
My most recent Waypoints post described the key differences between the Traditional and Roth IRA, and detailed the four main advantages of the Roth IRA over the Traditional IRA. Top of this list was the tax-free growth of your investment in a Roth IRA. With advantages like tax-free growth, why doesn’t everyone contribute to a Roth IRA?
The simple answer is that when Congress created the Roth IRA, it established income thresholds to limit which taxpayers could take advantage of this amazing retirement savings opportunity. For more than a decade, high earners were prevented from accessing the tax-free savings of Roth contributions. In 2010, Congress indirectly opened the Roth IRA door by allowing anyone, regardless of income, to convert their Traditional IRA into a Roth IRA - creating what we now call the Backdoor Roth IRA.
I’ve been told I make too much money to do a Roth IRA. Yes, because of these income thresholds, you may make too much money to contribute directly to a Roth IRA, but that doesn’t mean you have to miss out on the long-term benefits of tax-free growth. You can still take advantage of tax-free retirement savings by first contributing to a Traditional IRA, then converting those funds to a Roth IRA.
Do I need a Backdoor Roth IRA?
Each year, the IRS publishes income limits for the Roth IRA; exceed these thresholds and you are not permitted to make a regular “front door” Roth IRA contribution. How do you know if you need to use a backdoor Roth? First, you’ll need to know your Modified Adjusted Gross Income or MAGI, which is a tax term for your household’s total adjusted gross income with tax-exempt interest and several other deductions added back.
Applying the 2021 MAGI thresholds detailed below, you can see that if you file as a single taxpayer and your MAGI is less than $125,000, you can make a regular Roth IRA contribution. If your MAGI is greater than $140,000, you’ll need to use a Backdoor Roth IRA. If your MAGI falls between these two thresholds, you’re permitted to make a partial regular Roth contribution, then use the backdoor for the remainder of your IRA contribution. The MAGI thresholds for married filing jointly couples are slightly higher, see the details below.
Roth IRA Income Thresholds for 2021
Tax Filing Status: Single
Regular Roth IRA - MAGI less than $125,000
Partial Roth IRA - MAGI between $125,000 - $140,000
Backdoor Roth IRA – MAGI greater than $140,000
Tax Filing Status: Married Filing Jointly
Regular Roth IRA - MAGI less than $198,000
Partial Roth IRA - MAGI between $198,000 - $208,000
Backdoor Roth IRA – MAGI greater than $208,000
Using the Backdoor Roth IRA is a straightforward 3-step process
Step 1: Contribute to a non-deductible Traditional IRA and fund it to the 2021 maximum allowed contribution: $6000, plus an additional $1000 if you’re over the age of fifty. Make sure your contribution is invested in a money market account or settlement fund so your investment will have little or no gains during the time between your contribution and Step 2.
Step 2: Convert this Traditional IRA to a Roth IRA. To keep this step simple, maintain your Traditional IRA and your Roth IRA with the same investment company. At most investment companies, you can accomplish this conversion online. You should make the conversion as soon as the funds have cleared the company’s verification process. This limits the opportunity for your account to accrue taxable gains. In some cases, you’ll be able to make the conversion on the same day as your contribution; other firms will require you to wait anywhere from 1-5 days.
When you convert your Traditional IRA into a Roth IRA, you can expect to see a scary warning notice stating, “This is a taxable transaction” - which it is. Don’t panic. Because you’ve already paid taxes on your Traditional IRA contribution and you’ve been careful to convert your IRA within a few days of the original Traditional contribution, your tax bill will be $0 or nearly so. Even if you put it off until next week, if you invested it in a money market type account, your investment will have earned little more than a few dollars that will be taxable.
Once your money is in the Roth IRA, move it out of the settlement account into a mutual fund or exchange-traded fund (ETF) that is appropriate for your retirement timeline and your risk tolerance level. Now that your investment is tucked inside a Roth IRA, your earnings grow tax-free until you need them in retirement.
CAUTION: Be aware of the IRS’s Pro Rata Rule. If you have funds invested in previous years’ Traditional IRAs or in SEP IRAs, Simple IRAs, or rollover IRAs from a previous retirement account like the Thrift Savings Plan, the Backdoor Roth IRA just got a little more complicated and, potentially, a lot more taxable. This is because the IRS will apply a “pro-rata” rule to your conversion increasing how much of your conversion is taxable.
If you have any of these types of accounts, I strongly recommend you work with your financial planner to determine the most tax-efficient plan for your Roth conversions.
Step 3: Fill out the IRS Form 8606. When you file your taxes, you’ll need to complete a Form 8606 to document your conversion. This is critical because it ensures you don’t pay taxes twice on the same contribution. If both you and your spouse did a Roth IRA conversion, you each need to complete a Form 8606. If there was little to no gain in your account between Step 1 and Step 2, the bottom line on this form will be $0 or another very small amount.
The best way to minimize the taxes on your conversion is to 1) invest your Traditional IRA contribution into a money market account or settlement fund and 2) convert the Traditional IRA to a Roth IRA within a few days of your original contribution, before it has a chance to earn any gains.
Mastering the Backdoor Roth IRA can be a powerful tool in your retirement savings tool kit - but there are a few more details you will want to consider:
The “Pro Rata” Rule. When considering the Backdoor Roth IRA conversion, it is important to remember the tax impact other retirement account balances may have on your Roth conversion. If you’re not sure if this rule applies to you, consult a qualified financial planner who can help you avoid this potential tax pitfall.
Owning assets in a workplace retirement savings accounts like your Thrift Savings Plan or a 401(k) won’t impact your ability to do a Roth conversion; however, rolling these assets into a traditional IRA will definitely impact the tax consequences of a Roth conversion.
The decision to roll-over these types of accounts is an important conversation to have with your financial planner who can help you maximize your retirement savings and minimize your tax bill.
Is it legal? The “Backdoor” nickname may lead you to worry if this conversion process is on the up and up. Until a few years ago, many financial advisors were cautious about recommending Backdoor Roth IRAs because it was unclear how the IRS viewed this conversion, and specifically the timing of the conversion. Thankfully, in 2018, the IRS clarified its position by stating that no waiting period is required between the Traditional contribution and the Roth conversion.
What about my spouse? In most cases, both spouses can contribute to an IRA, even if one spouse has little or no earned income, and if you contribute to a non-deductible Traditional IRA, you can convert it to a Roth IRA. If both spouses take advantage of the Backdoor Roth IRA, you’ll want to be sure both spouses document the conversion with the IRS Form 8606.
Keep it simple. To keep your tax filing simple, it is best to complete both the Traditional contribution and the Roth conversion before December 31. Technically, you have until the tax deadline (generally April 15) of the following year to complete the contribution, but completing both steps within the same tax year simplifies your tax documentation.
Is it too late for 2020? No, technically you have until April 15, 2021, to make your 2020 non-deductible Traditional IRA contribution. The income thresholds listed in the table above are slightly lower for 2020, but the maximum contribution of $6000 (plus $1000 if you are over age fifty) still applies. Since your Roth conversion will now take place in 2021, a separate tax year from your original Traditional contribution, your tax filing will be slightly more complicated.
The 5-year rule. As with any tax-advantaged vehicle, the Roth IRA conversion comes with a few rules and tax penalties for violating them. One rule unique to the Roth conversion is the requirement that you wait at least 5 years before withdrawing any converted funds, this includes both your original contribution and your earnings. This 5-year rule applies regardless of your age. There are actually several “5-year rules” that apply to Traditional and Roth IRAs. I’ll cover these rules in more detail in a future post.
As always, specific investment decisions are unique to each individual’s situation. To ensure you’re making the right financial decisions, it’s important to work with a financial planner who understands what is most important to you and your family. I enjoy working with military families with whom I share common values and can build trusted relationships. To learn more about working with Tailwind Financial Planning, please schedule a free introductory call.
To better understand the differences between a Traditional IRA and a Roth IRA, read my previous Waypoints post.
