The so-called ‘backdoor ROTH IRA’ financial planning strategy has been around for a few years as a way for high income earners to get some money into a ROTH IRA. It provided a way to circumvent the income limits that prevent ROTH IRA contributions when you make too much money. Ever since ROTH IRA conversion income limits expired, the backdoor ROTH has become a very popular tactic that some financial planners have used in an attempt to shield some client money from taxes, while still meeting tax rules. Income limits prevented such a strategy for many years. That is, until recently.
While the IRS had never officially determined the backdoor ROTH to be fully compliant, they finally did so last week.
Now that this strategy can finally come out into the open, let’s go over how it works. It’s a two-step process:
- Make a non-deductible Traditional IRA contribution.
- Convert said non-deductible Traditional IRA contribution to a ROTH IRA.
That’s pretty much it. However, there are some moving parts that must be considered before utilizing this strategy.
First of all, if you’re going to convert money from a TRAD IRA into a ROTH IRA you’re going to be taxed on that money as ordinary income (Non-deductible contributions may not have tax consequences. Consult your tax advisor). If this bumps you up into a higher tax bracket, it may or may not be the best idea. Each situation is very different. Be very aware of the tax consequences of doing a ROTH conversion
Second, you should examine as best as you can, what your current tax situation looks like and how your tax situation may look during your retirement. Tying to predict what taxes will look like in the future isn’t very easy. I get that. With that said, you can still try to forecast things like where your income come from in retirement. Social Security? Pension(s)? Part-time employment? Drawdowns of your investments from an IRA, ROTH IRA, or a taxable account (each of those accounts and where the withdrawals come from have wildly different taxation consequences)? Try and plan out where most of your retirement income will come. It will make things easier on you during retirement.
Now let’s move to an example of why and how someone would want to complete a backdoor ROTH IRA.
Meet Ross and Rachel (The Wife and I have been watching old Friends episodes lately). Ross works at a museum and Rachel works as a buyer for a large department store. They don’t have any kids together and have been on again/off again in love since roughly 1997. Let’s say they’re married and their married filing joint gross income is $467,000 per year. (That’s about $39,000 per month in case you were wondering.) They make too much money to make a ROTH IRA contribution.
Alright, well how about a Traditional IRA contribution. I mean, they can at least deduct said contribution, right? Not with that level of income they can’t. However, they can still make a non-deductible Traditional IRA contribution though. As far as getting some money into a ROTH IRA I guess they’re just screwed, right?
Not if their financial and tax advisors work this strategy appropriately.
Here’s where the backdoor ROTH comes into play. Ultimately what the backdoor ROTH IRA strategy does, is allow high income earners a way to get money into a ROTH IRA, which is a tax-free account (provided they are qualified to do so).
Just like Ron Burgandy, it’s sort of a big deal.
The financial planner would advise Ross & Rachel to make a non-deductible Traditional IRA contribution and then convert that contribution to a ROTH IRA. It’s a pretty simple, yet powerful strategy that can have significant and lasting impact for the couple.
Up until last week, the backdoor ROTH strategy was sometimes forced to stay underground because the IRS did not have an official stance on it. It was forced to live in the shadows. Not anymore. With the IRS bringing it out into the open last week, the backdoor ROTH can finally emerge from the darkness. It can finally come out into the light where people can see it and use it.
It’s a great day for both high-income earners and financial planners alike.
Okay, that’s it. I’m done.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual, nor intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
Traditional IRA account owners should consider the tax ramifications, age and income restrictions in regard to executing a conversion from a Traditional IRA to a ROTH IRA. The converted amount is generally subject to income taxation. The ROTH IRA offers tax deferral on any earnings in the account. Withdrawals from the account may be tax free as long as they are considered qualified. Limitations and restrictions may apply. Withdrawals prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Future tax laws can change at any time and may impact the benefits of ROTH IRAs. Their tax treatment may change.
Hypothetical example is for illustrative purposes only and does not represent any investor situation. Your results may vary.