Backdoor Roth IRA. It kind of sounds like a James Bond backroom deal with important men in important suits discussing important things. But this strategy, is (thankfully) nothing like that.
In fact a backdoor Roth IRA, also known as a roth conversion, uses your existing retirement accounts to help you save the most money possible for retirement. Seems simple, but it can get a bit complex.
You may have heard this term thrown around a lot and have been confused on what it is and how it works. My team and I are here to help set the record straight on backdoor Roth IRAs, how they work, and what makes them special.
What is a Backdoor Roth IRA?
A backdoor Roth IRA is a conversion of a traditional IRA into a Roth (Roth conversion, get it?). Roth IRAs are great because they allow your money to grow tax-free in the account and since the money was taxed upon the contribution, it isn’t taxed on the withdrawal.
But as with most things concerning the IRS, there is a catch. Roth IRAs establish income limitations in order to contribute, meaning that if you make more than the income limit, you are not eligible to contribute money to that account.
Some people who exceed the income limit and want to contribute more than 6 grand choose to convert their traditional IRA into a Roth because there are no monetary limits on the conversion.
Seems pretty great right? But before you go all Transformers on your retirement accounts, you should take a look at how the conversion process works.
One super important caveat to note: you don’t actually avoid paying taxes! Ahh, you thought that you could get the tax benefit of both the traditional IRA on contributing and the Roth on withdrawal. Nope, sorry taxes are still a reality. Most likely the money you convert to the Roth (though limitless) will be taxed as income which could push you over into a higher tax bracket. Timing is everything when considering converting funds.
When is it used?
Most people who opt for backdoor IRAs do not qualify to contribute to IRAs in the traditional way. Due to the income restrictions, many high income earners are unable to contribute to a Roth IRA.
For example, in 2019 if your modified adjusted gross income exceeds $137,000 if filing single, or $203,000 if married and filing jointly you are not able to contribute. For 2018, the limits are $135,000 single and $199,000 married filing jointly. With a backdoor Roth IRA, these income limits can’t be enforced.
Roth IRAs also have contribution limits, $6,000 ($7,000 if over 50) per year for 2019. The 2018 limits are $5,500 and $6,500 if over 50.
In order to enjoy the tax benefits of a Roth IRA without qualifying, Congress has sanctioned another path.
Is it “incorrect”?
Backdoor IRAs are not illegal, nor are they incorrect. They are a bit unconventional and they do carry some risks. Let’s take a look at a few common ones.
- You have to earn income
- In order to go in the back door, you first have to go through the front. Meaning that in order to convert funds you must have earned income either through wages or self-employed income to be qualified.
- There are still age restrictions
- If you are like, wait I just avoided income restrictions now I have to worry about age? I get it, but yes, you do. Traditional IRAs do not allow contributions past age 70 ½. If you are older and can’t contribute funds to a traditional IRA, you can’t then convert any money to a Roth.
- The pro rata rule is held up
- The pro rata rule deals with the taxation of money throughout all of your IRAs. You only have to really worry about this rule when you have both pre-tax and after-tax dollars nestled in your IRA. For this rule think of all your IRAs under one umbrella.
- Conversion vs Contribution
- When you convert money into a Roth IRA, that money is converted not contributed. With that, the converted money falls under the 5 year hold which means you cannot touch the money without penalties for at least 5 years.
What makes it so interesting?
Backdoor Roth IRAs offer a path for high income earners to contribute to this type of account when they were unable to before. It provides an avenue for people to be able to grow a Roth IRA when they are unable to actually contribute to it. These accounts can be valuable come retirement time because they do not have required minimum distributions (RMD) and all withdrawals are tax and penalty free.
This conversion tactic is not without its drawbacks, and having a handle on those will help keep your tax bill low and your savings high. If you are interested to see if this strategy could work for you, give us a call!