Backdoor Roth IRA Mechanics

One of my multitude of regular readers requested that I do a post about the mechanics of what is known as the “backdoor” Roth IRA. Since tax time is around the corner, here we go.

What is a “Backdoor” Roth IRA?

A “backdoor” Roth IRA is a contribution to a Roth IRA made by a person who does not meet the normal requirements to be eligible to contribute directly to a Roth IRA.

To make a backdoor Roth IRA contribution, this is all you need to do:

  1. Make a contribution to a traditional IRA with your brokerage firm of choice.
  2. Ask the brokerage to move the money in the traditional IRA account to a Roth IRA account.

You can continue reading to figure out if this would be something worthwhile for you to do.

In 2017 (and 2018) every taxpayer is eligible to contribute a total of $5,500 ($6,500 if over 50) towards an IRA (either a traditional IRA or a Roth IRA).

Roth IRA Contributions

Contributions to a Roth IRA are taxed in the year that they are made. But they grow tax free and are not taxed upon withdrawal. However, if you exceed certain income levels, you cannot make direct contributions to a Roth IRA.

Those amounts for single taxpayers are $133,000 (phaseout beginning at $118,000) in 2017 and $135,000 (phaseout beginning at $120,000) in 2018.

And, they are $196,000 (phaseout beginning at $186,00) in 2017 and $199,000 (phaseout beginning at $189,000) in 2018 for married joint filers.

Full information, including where phaseouts begin, can be found here for 2017 and here for 2018.

Deductible vs. Non-Deductible Traditional IRA Contributions

Contributions to a traditional IRA account work a little differently depending on your income level. While there is no income limit for a traditional IRA contribution, your income and employer retirement account eligibility determines whether you are able to deduct your contributions to a traditional IRA from your taxes.

If neither you nor your spouse (if you have one) are covered by a retirement plan at work, you can make a deductible contribution to a traditional IRA regardless of income.

If you (or your spouse) can contribute to a retirement plan at work, then you cannot deduct your contribution if you exceed certain income threshold levels. If you are single, those limits are $72,000 (phaseout beginning at $62,000) in 2017 and $73,000 (phaseout beginning at $63,000) in 2018. If you are married, those limits are $119,000 (phaseout beginning at $99,000) and $121,000 (phaseout beginning at $101,000) in 2018.

Full information, including where phaseouts begin, can be found here.

If you are able to make a deductible contribution to a traditional IRA, you are able to deduct that amount from your taxes for that tax year. And, the earnings in your traditional IRA grow tax free. However, when you pull the money out of the IRA upon retirement, all of the money you take out is treated as ordinary income and taxed at ordinary income tax rates.

If you make a non-deductible contribution to a traditional IRA, you are not able to deduct the amount you contribute. However, the earnings on the account still grow tax free from year to year. Then, when you take money out of the account, you do not have to pay taxes on the contributions upon withdrawal. But, you do have to pay tax on the earnings on withdrawal. For example, if you made a contribution of $5,500 in 2017 and that grew to $16,500 by 2047 when you retired, when you withdrew the money you would only pay taxes on $11,000 ($16,500 – $5,500).

The “Backdoor” Roth

Taxpayers whose income is too high to contribute to a Roth IRA (as discussed above) and who are eligible (or have a spouse who is eligible) to contribute to an employer sponsored retirement plan are limited to making non-deductible traditional IRA contributions. Those have limited tax advantages as compared to Roth or deductible traditional contributions.

However, taxpayers in this situation can take advantage of the “Backdoor” Roth.

In order to do so, the taxpayer would first make a non-deductible contribution to a traditional IRA. They then would perform a conversion of the traditional IRA to a Roth IRA. This is accomplished at most IRA providers by simply requesting the money be transferred from the traditional IRA to a Roth IRA. This has been possible since 2010, when income limits on Roth conversions were lifted as part of the Tax Increase Prevention and Reconciliation Act of 2005.

Roth IRA conversions are taxable events. If you are converting DEDUCTIBLE traditional IRA money to a Roth, the entire amount of the conversion is taxed. However, if you are converting NON-DEDUCTIBLE traditional IRA money to a Roth, only the earnings are taxed.

Therefore, if you make the conversion fairly soon after making your non-deductible contribution, there should be close to no (if any) tax consequences of the conversion. This is because you should have little or no earnings if you do the conversion soon after making the contribution.

For example, say you made a non-deductible traditional IRA contribution of $5,500 on March 1. Let’s say that that grows to $5,501 by March 2 when you perform your Roth IRA conversion. You would only pay tax on the $1 of earnings. But the $5,500 you contributed would convert tax free.

Some people have worried that doing the conversion so quickly would be treated as an illegal direct IRA contribution due to something called the “Step Transaction Doctrine.” This year, however, congress seemingly has co-signed this as legal. In footnote 269 on page 289 of the house resolution in the recent tax bill, it says:

Although an individual with AGI exceeding certain limits is not permitted to make a contribution directly to a Roth IRA, the individual can make a contribution to a traditional IRA and convert the traditional IRA to a Roth IRA.

Again, to make a backdoor Roth IRA contribution, this is all you need to do:

  1. Make a contribution to a traditional IRA with your brokerage firm of choice.
  2. Ask the brokerage to move the money in the traditional IRA account to a Roth IRA account.

Warning: if you have made deductible traditional contributions in the past the Backdoor Roth probably won’t work for you

The “Backdoor” Roth IRA only works properly if you have a balance of $0 in traditional IRA accounts. Note, if you have money in a traditional 401(k) account, that is completely fine.

The reason it only works if you have $0 in your traditional IRA accounts is that conversions to Roth IRAs are done on a pro-rata basis.

Let’s say, for example, you were eligible to make deductible traditional IRA contributions in the past and have a balance of $55,500. And, let’s say that this year you made a non-deductible traditional IRA contribution of $5,500. Your total traditional IRA balance would now be $61,000 ($55,500 that has not been taxed and $5,500 that has been taxed). That is 10 out of every 11 dollars in your traditional IRA account would be money that has never been taxed.

When you make a Roth conversion, the government does not allow you to pick out only the non-deductible amount to convert. Instead it is done on a pro-rata basis. For example, if you tried to convert $5,500 in the example above, $5000 (10/11) would be taxed and only $500 (1/11) would be converted tax free.

Don’t wait until next year to make your IRA Contribution!

One final note, you don’t need to wait until tax time to make IRA contributions. You can make your contribution for 2018 right now. And, assuming you know what your tax situation for the year is, you should! You get an extra 16 months of potential growth by making your contribution in January of a given tax year instead of waiting until April of the following year.

Disclaimer: I’m not a qualified tax professional, figure this stuff out yourself with the help of a real one. Also, the picture at the top of this post is a front door.

 

 

 

 

 

 

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