With several individual retirement account (IRA) options available to investors, it’s important to understand how each IRA works and which is most appropriate for you. In this piece, we’re going to dive into the Backdoor Roth IRA conversion.
Roth IRA Basics
The key distinction with a Backdoor Roth IRA is that it has been converted from a traditional IRA to a Roth IRA. Investors are primarily interested in Roth IRAs because they allow money to grow and be withdrawn tax-free, as long as the withdrawals occur after you have held the Roth IRA for at least five years and have reached age 59.5. In addition, Roth IRAs do not have annual Required Minimum Distributions, as defined by the IRS. This means you are not mandated to make annual withdrawals from a Roth IRA after you reach age 70.5, which are required with a traditional IRA.
Because individuals whose income is above a certain threshold cannot contribute to a Roth IRA, Backdoor Roth IRAs are becoming increasingly attractive to higher earners who want to obtain the benefits of the Roth investment vehicle. If you make more than $122,000 annually as a single, individual tax filer, you cannot contribute to a Roth IRA through normal means. Married couples making more than $193,000 annually are also not allowed to contribute to a Roth IRA.
Setting Up A Backdoor Roth IRA
If you already have a traditional IRA or are looking to set up a traditional IRA, it is simple to convert to a Roth IRA. Once the traditional IRA is set up, it can be funded with non-deductible contributions and the conversion can occur shortly after.
Be advised that you will be responsible for paying taxes on the conversion. Nerdwallet has a helpful guide that walks you through the simple steps of a Backdoor Roth conversion. Since only post-tax dollars can be contributed to a Roth IRA, any tax deductions previously claimed on traditional IRA contributions must be repaid during the Backdoor Roth conversion.
Things To Watch Out For
When paying taxes on the conversion, it’s prudent to not use funds within the IRA itself. This would be considered a withdrawal from a Roth IRA. Withdrawals made during the five-year waiting period and before age 59.5 are subject to a 10% early withdrawal penalty. It’s also important to understand the return you need to achieve and the time horizon necessary to achieve it in order to cover the taxes paid during the conversion.
The IRS has a pro-rata rule which dictates the proportion of pre- and post-tax contributions that apply to the IRA funds you convert. For example, in your traditional IRA account, you may have 80% of the funds designated as pre-tax, while the other 20% are post-tax. The IRS will not allow you to only convert the post-tax funds, thus, avoiding paying back the tax deduction received for the pre-tax contributions. Instead, the IRS applies the proportion of pre- and post-tax contributions within the total traditional IRA account to the Roth conversion amount. In this Morningstar article, there are several tips for avoiding common mistakes made during a Backdoor Roth IRA conversion.
There are income tax risks to consider as well. Funds converted from a traditional IRA to a Roth IRA will be considered taxable income in the year of conversion. Therefore, it’s important to review the implications of a conversion with a tax advisor to understand if a conversion will bump you into a higher tax bracket.
Is The Backdoor Roth IRA Conversion Right For Me?
For high earners, a Backdoor Roth can be a beneficial investment vehicle that allows their money to grow tax-free. However, there are plenty of risks to keep in mind. In any complex investment or retirement decision, it is prudent to talk to your financial advisor to see which planning strategy is right for you.
If you’re interested in setting up an appointment with an advisor to learn more about Backdoor Roth IRA conversions, send us an email at email@example.com.