Photo by Michael Longmire on Unsplash
Roth IRAs offer tax-deferred growth, access to your principal, avoid Required Minimum Distributions (RMDs), tax-free qualified distributions, and they pass to your heirs tax free. If you believe that tax rates (or your taxable income) will be higher in the future than it is today, Roth IRAs offer a tax-smart strategy for your retirement savings.
Unfortunately, many people do not qualify to contribute to Roth IRAs because their income is too high. Roth IRA income phaseouts for married taxpayers with adjusted gross incomes (AGI) who file jointly begin at $198,000 and phases out altogether at $208,000 of AGI. For single filers, the phaseout begins at $125,000 and is completely phased out with an AGI of $140,000 or more. You can get specific numbers for your AGI on this chart.
There is a workaround, however. Known as the backdoor Roth IRA, the IRS allows anyone with earned income to contribute to a traditional IRA regardless of how much they earn (deducting your contribution from your taxable income is another matter). They also allow all IRA owners to convert traditional IRAs to Roth IRAs at any time, again, regardless of their income.
Here is the workaround: Contribute to a traditional, non-deductible IRA now and convert it to a Roth IRA later. Voila! You have effectively contributed to a Roth IRA even though your income may be too high to contribute to one directly.
There is no specific, IRS defined, time period that one must wait to convert their IRA to a Roth. Once the contribution is made, the conversion can be completed. For practical and record keeping purposes it may make sense to wait at least 30 days to convert to a Roth IRA, but that’s just a procedural preference.
Converting IRA assets to Roth IRA assets is simple enough. Unless…. You have existing, pre-tax IRAs.
The headache comes when you do your taxes. All conversions are taxable events. If the only IRA you own is a non-deductible IRA, the taxable amount is essentially $0 since you never took a tax deduction in the first place. This is the ideal situation for a backdoor Roth IRA – every year you contribute the maximum amount to a non-deductible IRA and convert it to a Roth IRA 30 days later. There is no tax due since you never took a tax deduction on your contribution and have no tax-deferred earnings or gains.
However, the IRS views ALL your various IRA accounts (including SEP and SIMPLE IRAs) as one big IRA. So, if you have one or more IRAs in addition to the non-deductible IRA you just converted, the tax math gets more complicated.
The Pro-Rata Rule. Since the IRS views all your IRA accounts as one big IRA, when you convert your non-deductible IRA to a Roth the taxable amount equals the prorated amount that the pre-tax IRA balances represent of your total IRA balance.
Here’s an example. You have a pre-tax IRA with a value of $95,000. You just made a non-deductible IRA contribution of $5,000. Even though you own two different IRAs, from the IRS’ point of view you have one IRA worth $100,000; 95% of which is completely taxable, and only 5% of which is tax free.
When you convert the $5,000 IRA to a Roth IRA, the IRS considers 95% of that converted amount to be taxable income. You now owe tax on $4,750.
So now what? If all your pre-tax retirement savings exists in your 401k or 403b plan at work, no problem. Use the backdoor Roth IRA. If your pre-tax IRA balance is relatively small, consider converting those IRAs to a Roth first (Note: Conversions are taxable events. Since you may owe tax on this conversion, make sure you have after-tax funds available to pay any taxes that may be due). Now you have a clean slate and you can do the backdoor strategy in the future. If your pre-tax IRA balance is relatively large, you may want to avoid the backdoor Roth IRA altogether.
Of course, the best IRA strategy will always depend on your income, whether or not you have a retirement plan at work, current tax rates, and your expectation for future tax rates. Do your math carefully and consult your financial advisor or tax professional regarding the best strategy for you.
For additional information, check out these resources:
Natalie Choate, MorningStar Contributor
Although the information has been gathered from sources believed to be reliable, it cannot be guaranteed and the accuracy of the information should be independently verified. This material was created to provide general information on the subjects covered but should not be regarded as a complete analysis of these subjects. It is not intended to provide specific legal, tax or other professional guidance. Individuals are encouraged to seek advice from their own tax or legal counsel for their individual situation.
To discuss any of the topics in this blog or to learn more about how we can help you Cross The Bridge To A Confident Retirement, please contact me through my web site mikebranch.net, call me directly at 651-379-3935 or email me at mpbranch@focusfinancial.com.