Are you interested in reducing your taxes as much as possible?
Does your current income make you ineligible to contribute to a Roth IRA this year? (if you’re a married couple, you’re ineligible if you jointly make over $191,000, if you’re single, you’re ineligible if you make over $129,000)
Do you feel taxes will be higher in the future?
If you answered “yes” to any of these three questions, it may be worth your while to consider a backdoor Roth IRA.
With a Roth account, not only do you allow your hard earned money to grow tax-free, but you also withdraw those funds tax-free in retirement (NB: don’t forget, you do pay tax upfront in that you contribute with after-tax dollars). On the other hand, in practice, the backdoor Roth IRA comes with its limits– and complications. As such, it doesn’t always beat other retirement savings account options.
In this post, I review the backdoor Roth IRA process and illustrate why they’ve become popular since 2010, when income limits for Roth conversions were removed. I then review the limitations and drawbacks of backdoor Roths to help readers decide whether this path may be worth pursuing.
WHAT IS A BACKDOOR ROTH IRA?
Two Step Process For Creating a Backdoor Roth IRA:
Step 1: Contribute to a (nondeductible) traditional IRA. Unlike a Roth IRA, the traditional IRA has no income ceiling for contributors.
Step 2: After the funds clear, convert the traditional IRA to a Roth IRA in order to never pay taxes again on your investments. Since no time has elapsed, there are no earnings on those funds and it’s a non-taxable event (unlike if you were to convert a deductible IRA into a Roth, in which case you pay an upfront tax at your current rate).
A backdoor Roth IRA is a solution for investors who make too much income to qualify for normal Roth contributions, and want to increase their retirement savings in tax advantaged accounts. Specifically, this is an additional retirement saving alternative for investors who have maxed out the $17,500 (with $5,000 additional catch up contributions for those over age 50) allowable contribution limit for workplace retirement plans and want to contribute more to a tax advantaged retirement account.
In general, it’s a good idea to contribute the maximum allowable by law to your workplace retirement account before creating a backdoor Roth IRA (see the Daily Capital post, Retirement Savings: Start with Your 401k for more detail). And if you decide to contribute to a backdoor Roth for multiple years, the process must be repeated each year and can’t be automated.
For example, Fauzia is a single 40 year old senior engineer who earns $127,999 per year who contributes $17,500, pre-tax to her workplace 401k. Fauzia would like to increase her retirement contributions and implements the backdoor Roth strategy. She opens a traditional IRA and contributes $5,500 of after-tax dollars. After the money clears, she instructs the IRA administrator to convert the contribution to the traditional IRA to a Roth IRA. Unless there was a change in the value of the assets in the short time, she doesn’t have to pay any additional taxes – and thus has effectively set up a Roth even though she exceeds the income limits. Fauzia legally contributed $23,000 to her retirement savings which will grow tax free.
BENEFITS OF A ROTH IRA
The main tax benefits of a Roth are that any money (contributed after tax) grows tax-free and is withdrawn without any further taxation. Further, unlike a traditional IRA, there are no required minimum distributions and the Roth IRA can be passed on to one’s heirs. This allows the funds to grow tax free over many years, and offers tax-free compounding and withdrawals (Here’s a quick primer on the Roth IRA benefits if you’d like to read more).
For example, Javier is age 40 and contributes $5,000 to a backdoor Roth and invests in a diversified portfolio of stock and bond funds with an average annual return of 7%. This contribution could grow and compound for as long as he desires. He never needs to take the money out of the account and can pass it on to his heirs. Consider the power of compounding over time; at age 70, the $5,000 contribution made 30 years ago with no additional contributions is worth ~$38,000.
Had Javier left the money in a nondeductible traditional IRA, the original contribution would still be worth $38,000 by the time he’s 70. However, Javier would have to begin withdrawing by the end of the year. He can either withdraw the entire amount or at minimum, the “required minimum distribution” (the market value divided by the applicable life expectancy factor, which ends up being ~3% for a 70-year-old and 15% for a 100-year old) . Further, he’d have to pay tax on those distributions. As you can see in Javier’s case, the backdoor Roth was clearly preferable to the nondeductible traditional IRA.
So for readers: is it time to call your advisor to get started on a backdoor Roth? Not so fast. It turns out that the above examples are overly simplified. In reality, the backdoor Roth has complications that make it less appealing than it might appear on the surface. In the following sections, I outline the factors that should make you pause – or halt – when considering a backdoor Roth IRA.
WHO DOESN’T NEED A BACKDOOR ROTH IRA?
1) If you are satisfied with the maximum retirement limit through your workplace retirement account (401k contributions are pre-tax are often accompanied by an employer match – making them the optimal retirement savings vehicle in most cases) and are not planning on additional retirement savings, you don’t need a back door Roth IRA.
2) If you already have money in a traditional IRA, because of the pro rata rule (read on to the next section to learn about this rule) it may not up being advantageous from a tax perspective to convert.
3) If you are unwilling to keep the funds in the newly created Roth IRA for at least five years before withdrawing the money. Because a backdoor Roth is considered a conversion and not a contribution, the funds will incur a 10 percent penalty if withdrawn within five years unless you are age 59 ½ or older.
4) If you are in a high tax bracket now and expect to be in a lower tax bracket upon retirement, you may want to keep the money in the traditional IRA.
5) If you plan to relocate to a lower income tax state or a state where there are no income taxes (Texas, Wyoming, Nevada, Alaska, Florida, Washington, and South Dakota).
6) If you are over than age 70 ½ you’re ineligible to contribute to an IRA and thus can’t utilize the back door Roth IRA strategy.
BEWARE OF THE PRO RATA RULE
The pro rata rule is the main complication of the Roth – even if it otherwise sounds like it might be for you. How it works: if you have any other deductible IRAs (for instance, an old 401k that you’ve rolled over), the conversion of any contributions becomes a taxable event that you’ll need to pay taxes on upfront.
But wait, didn’t we say that because any contribution to a backdoor Roth comes from an immediate conversion from a nondeductible IRA, it’s a nontaxable event? Yes, but there’s a big exception: if you own any deductible IRAs. In that case, you are taxed upfront on the pro rata amount of the conversion (the conversion value divided by your entire IRA value) that was deductible. This may sound complicated, I’ll help walk you through this tax issue in an example.
Assume Michelle has $95,000 of IRA money spread out in various accounts. Even though these are in separate accounts, the IRS considers them as one IRA. Michelle then contributes $5,000 into a non deductible traditional IRA, and soon after transfers that $5,000 into a Roth IRA, utilizing the backdoor Roth strategy.
If Michelle had no other IRAs, the conversion to the Roth IRA would be tax-free. Since Michelle has other IRA assets, this is not the case.
The pro rata rule requires Michelle to consider all of her IRA money that hasn’t been taxed yet and views the $5,000 as a percent of the total IRA pool of (non taxed) funds. The $5,000 converted to a Roth is considered 5% of her total IRA assets ($5,000/$100,000). Her percentage of deductible funds in her IRA is therefore 95%, and upon conversion she owes a tax upfront on $4,750. As you can see, the backdoor Roth picture is quite different here and in most cases should be advised against.
IS A BACKDOOR ROTH IRA FOR YOU?
Given all of the benefits outlined, Backdoor Roth IRAs are certainly something to consider when you’re charting out your retirement savings. Namely, if you’ve already maxed out other retirement savings options, you’re willing to leave the money in the Roth for at least five years, and you expect to be in a higher tax bracket in retirement, it’s something to consider.
However, Backdoor Roth’s are not for everyone, so if you do consider it – chart your course carefully. If you already have traditional IRA or have room in other retirement savings vehicles, make sure to do the math to see if this is for you. You can always reach out to a Personal Capital Financial Advisor to discuss the pros and cons of this strategy and how it applies to your own situation. Or you can simply sign up to use Personal Capital’s free Financial Dashboard to track your finances.
Readers, have you considered doing a backdoor Roth IRA? Who is most suitable for doing a backdoor Roth IRA? Do you will pay more taxes in retirement than when working?
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