Summary - The Roth IRA was introduced to investors 20 years ago. The Roth IRA presents investors with a strategy that allows tax-free growth of capital gains and contributions. A Roth IRA allows investors to make after-tax contributions to a retirement plan. For investors who do not have an employer retirement plan, such as a 401(k) that allow contributions based on pre-tax income, or are making a contribution from self-employment income, a Roth IRA can be an attractive option. While their Roth contribution is an after-tax contribution, money inside a Roth account can grow and be withdrawn without a tax penalty. A Roth IRA also allows contributions after the age of 70 1/2, nor does it have required minimum distributions once investors turn 70 1/2. However, for all its advantages, a traditional Roth IRA has income limitations that make it difficult for investors who have a high taxable income to participate. The income limits that will allow making a contribution to a Roth account, a single taxpayer must have an adjusted gross income of less than $135,000 and couples who are married filing jointly must have an adjusted gross income of less than $199,000.
To help these high-income earners who are in a high tax bracket enjoy these benefits, the IRS has been allowing them to have a Roth account by making what is called a backdoor Roth IRA conversion. A backdoor Roth IRA is more of a strategy than a product. The basic way for investors to execute this strategy is to make a non-deductible contribution to a traditional IRA account and then doing what is called a backdoor Roth conversion that allows them to have all the benefits of a Roth IRA. Because they already had to pay taxes on the initial contribution, the gains, and subsequent withdrawals can continue to grow tax-free.
Saving for retirement is more important than ever. Retirees are living longer and due to advances in medicine are enjoying a better quality of life. That’s the good news.
The bad news is found in studies that show many investors at or nearing, retirement age have retirement accounts that are underfunded. There are several reasons for this beyond the idea of “they just haven’t saved enough”. One reason may be investors are not getting all the tax advantages that they can. They may also be getting limited by their inability to make contributions past the age of 70 1/2, or they may be seeing their nest egg eroded due to required minimum distributions. Any or all of these can be specific reasons why even the best-intentioned investors are falling short.
One of the relatively recent products available for investors to fund their retirement is the Roth IRA. The first Roth IRA was introduced as part of the Tax Relief Act in 1997. Two of the most appealing provisions of a Roth IRA were the ability to make contributions after the age of 70 1/2 and the removal of the minimum withdrawal requirement after turning 70 1/2. Roth IRAs also presented investors with a different way to think about taxes. In traditional IRAs, contributions are tax-deferred which means that the individual is not taxed until the money is withdrawn from the account. In the case of a Roth IRA, contributions are made from pre-tax income front but withdrawals are tax-free.
However, in return for these benefits, there were income restrictions made on Roth IRAs that make higher income earners ineligible for a Roth IRA. That is unless investors take advantage of a loophole in the current tax code known as the Backdoor Roth IRA. This is a perfectly legal way for investors who would otherwise be ineligible to have a Roth IRA to take money from a traditional IRA and convert it to a Roth IRA.
In this article, we’ll break down what a backdoor Roth IRA is, the steps investors need to take every year, and we’ll review some of the things to avoid when setting up one of these accounts.
What is a Backdoor Roth IRA?
A backdoor Roth IRA is not a financial product, but rather a strategy that high-income earners can use to put retirement savings into a Roth IRA. Although the name implies that this process is of questionable legality, the backdoor Roth IRA is sanctioned by the Internal Revenue Service.
A traditional Roth IRA is funded with after-tax contributions that are taxed at the investor’s current taxable rate. However, because they are after-tax contributions any growth and subsequent distributions in the Roth IRA are tax-free. When you consider that Roth IRAs do not require that owners take a minimum withdrawal every year and can, in fact, make additional contributions they have become a key source for generational wealth.
But as of 2018, single taxpayers with an adjusted gross income at or above $135,000 and married taxpayers filing jointly with an AGI of $199,000 or higher are not eligible to contribute to a traditional IRA. However, in 2010, the IRS created a loophole that gave higher-income investors the opportunity to open a Roth IRA by converting a traditional IRA. Here’s how it happened. In 2010, the IRS did not put an income limit for converting a traditional IRA to a Roth IRA. This created an opportunity for higher-income taxpayers to open a Roth IRA using the contributions in their traditional IRAs. It opened up the “backdoor” to the benefits of a Roth IRA.
How do investors open a backdoor Roth IRA?
There are two ways for investors to open a backdoor Roth IRA. The first option is for investors to make a contribution to a traditional IRA (this is non-tax-deductible) and then convert it to a Roth IRA. It is best to do this within the same tax year. The second option is to make an after-tax contribution to a 401(k) plan and then rolling that contribution over to a Roth IRA.
Here is an exact breakdown of how to do this:
- Make a non-deductible contribution to your traditional IRA– Individuals can contribute up to $5,500. If married, that can be $5,500 each for an investor and their spouse. Investors over the age of 50 can also elect to make a catch-up contribution that allows them to contribute an extra $1,000 to their traditional IRA.
The very important words here are “non-deductible”. If you are making pre-tax contributions to an employer-sponsored 401(k) those contributions are not eligible to be converted to a backdoor Roth IRA. The reason is simple, the IRS is allowing this loophole to stay open, but the money has to be taxed at some point.
This may mean you have a designated IRA specifically for transferring to a Roth IRA. This account would be funded at the beginning of the year and then the money would be transferred to your Roth IRA. If the account stays at a zero balance, that’s OK. Most mutual fund companies will not close your account. You can make your contribution into a Money Market component of that IRA so that the amount you contribute will be the same as what you convert.
One word of caution, in many cases, it is advantageous for investors to have both traditional IRA accounts and Roth IRAs. However, for investors planning on taking advantage of the backdoor Roth IRA, the funds should come from a traditional IRA designated for that purpose. This ensures there is no capital gain or loss on the money. Also, for reasons, we’ll explain later, if you do want to maintain a traditional IRA apart from your Roth IRA, make sure it is an individual 401(k).
- Transfer (or convert) the money to a Roth IRA –This is as simple as transferring money from one bank account to another. In this case, you’re just transferring it from your traditional IRA to a Roth IRA. A good idea is to make sure to choose a mutual fund company that offers both traditional and Roth IRAs. This makes it very simple to transfer money from one account to another. Also, if you’ve never done one of these transfers before you might panic when you are alerted that making this transfer will trigger a taxable event. But in this case, the tax will be zero. Why? Remember the contribution made in Step One was “non-deductible”. The investor has already paid taxes on the money AND makes too much money to claim it as a deduction.
- Properly fill-out Form 8606 for the tax year of the contribution- It is extremely important that this form is filled out properly. First of all, failure to fill one out is illegal, and second, if you don’t fill it out, you will probably pay too much tax – and nobody wants that.
The process is really that simple. And to maximize the benefits you just continue to repeat the same process year after year, allowing your contributions into your backdoor Roth IRA to grow tax-free.
Do contributions and conversions have to be done in the same calendar year?
The short answer is no, but it is the simplest way to makes sure you are getting all the tax-free growth you can. All contributions and conversions must be done prior to your tax filing date in the next year. So, you technically have until the time you file (around April 15th) of the next year to make a contribution and conversion. And if you don’t make the conversion for that tax year, you can make it the following year – or 10 years down the road. There is no deadline for when you have to convert. However, form 8606 becomes a bit more complicated for you and/or your tax preparer if you wait to do a conversion.
How the Pro-Rata rule affects backdoor Roth IRAs
In the simplest form, you want to make sure the balance on any non-401k, traditional IRA accounts is zero at the end of the tax year for which you are converting to a backdoor Roth IRA. Prior to 2010, products such as SEP-IRA and SIMPLE IRAs can be an effective choice for building retirement savings if you’re self-employed or have a practice (doctor, lawyer, etc.). However, if you have money in any of these accounts at the end of the tax year that you are making a contribution to a backdoor Roth IRA it will be subject to what is called the pro-rata rule.
This is because, when it comes to accounting for distributions from your IRAs, the IRS treats all your IRAs (except for Roth IRAs) as one big IRA. So if you take a deduction from one IRA, you are required to list the balance of all existing IRAs (except for Roth IRAs) and the remaining funds will be taxed on a pro-rata basis. 401k accounts fall outside of the pro-rata calculation.
There are three ways to get rid of these accounts: the easiest way would be to roll the money over into a 401k, 403B, or Individual 401k. Another option would be to convert the entire amount into a Roth IRA. However, this should only be done if the amount is very small because you will have to pay takes out of your current earnings or other taxable investments. The least recommended option would be to cash out but that would subject the funds to tax and penalties.
Does the Step Transaction Doctrine affect a backdoor Roth IRA?
The Step Transaction Doctrine is a scary IRS rule that says, in essence, you can’t do a bunch of legal things if the end result is illegal. Some investors have been scared off from doing a backdoor Roth IRA for fear that it would fall under this doctrine. However, in 2018, the IRS essentially validated the entire process when it clarified that there was no requirement for investors to wait from the time they contribute to a traditional IRA and transfer to a Roth IRA. In fact, some investors will make a contribution on the first business day of the New Year and make the conversion the very next day (or even the same day if their fund allows it).
What a backdoor Roth IRA is not
A backdoor Roth IRA is sometimes confused with a Roth Conversion. However, there is a key difference when it comes to taxes. With a backdoor Roth IRA, there is no tax cost. Yes, when you do the conversion the site may say you are triggering a tax event, but if you do the conversion the right way you’re not. A Roth conversion will almost always trigger a tax event.
A backdoor Roth IRA is also not the same as a Roth 401(k) contribution. In the case of contributing to a Roth 401(k), the decision is it better to make a tax-deferred contribution now or receive tax-free money later. There are plenty of factors that go into to that decision. When deciding whether or not to do a backdoor Roth IRA, the question is simply do you want taxable growth or tax-free growth? That’s a much simpler answer.
The bottom line on backdoor Roth IRAs
A backdoor Roth IRA is a legal way for high-income earners to establish and continue to make contributions to a Roth IRA even though they exceed the income limits to set up a traditional Roth IRA.
In addition to the distributions growing tax-free inside of a Roth IRA, a Roth IRA has two major advantages that investors are looking for in their retirement accounts. One is the ability to make additional contributions after the age of 70 1/2 and the other is that there is no required minimum distribution which makes them a great vehicle for passing wealth along.
In order to set up a backdoor Roth IRA, an individual must first make a non-deductible contribution into a traditional IRA. This can be up to $5,500 for an individual and an additional $5,500 if they are filing taxes jointly with a spouse. This amount can be as high as $6,500 for individuals over the age of 50 who are making catch-up contributions. After making the contribution to the traditional IRA, they simply transfer the money to a Roth IRA. Although there is no time limit for this conversion to happen, the majority of filers will do it in the same calendar year to get the most tax-free growth.
Individuals who are setting up a backdoor Roth IRA should take care to ensure they do not have existing money in another IRA to avoid the pro-rata calculation. The exception to this is a 401(k) account which is not subject to the pro-rata calculation. In 2018, the IRS reaffirmed that there was no deadline on when contributions to a traditional IRA could be converted to a Roth IRA. This ensures the backdoor Roth IRA is not subject to the Step Transaction Doctrine.
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Agriculture stocks have a place in every investor's portfolio. The fact is that the byproduct of agriculture literally feeds the world. But for a variety of reasons, supply and/or demand can be disrupted. For example, the weather is often a concern. Farmers are always subject to periods of drought or flooding.
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