Roth IRAs are an increasingly popular retirement savings vehicle because they allow retirement savers to generate tax-free income and are not subject to the required minimum distributions associated with a traditional IRA. Yet, despite the long-term tax savings they offer, less than a third of IRA investors have one of these accounts. This disparity could be the result of account income limits, which prohibit taxpayers above certain income levels from investing directly into a Roth IRA.
However, even if you are above the allowed adjusted gross income, you can still invest in a Roth IRA via a “backdoor” Roth IRA, a strategy that allows you to invest money that has already been taxed and allows the earnings to grow tax-free.
How does a backdoor Roth work?
As of 2017, married couples filing jointly with a modified adjusted gross incomes (AGI) of $196,000 or more can't make direct contributions to a Roth IRA, and neither can a single person with a modified AGI of $133,000 or more. Meanwhile, single people with a modified AGI between $118,000 and $133,000 can only make reduced contributions to a Roth IRA. The contribution limit begins to decrease from the full $5,500 (or $6,500 if you are over age 50) to $0 after their income passes the $118,000 mark.
Let’s assume you are prohibited from depositing directly into a Roth IRA. To create a backdoor Roth, deposit the maximum amount permitted in a traditional IRA. Since these monies are taxed (you are prohibited from contributing to a traditional IRA tax free), the backdoor Roth is completed by immediately converting the traditional IRA into a tax-free Roth IRA (hence, the backdoor!) Make sure you do this quickly, before the traditional IRA receives earnings.
It is important to note that leveraging a backdoor Roth IRA may not be practical if you have a large balance in a traditional IRA. Ideally, to maximize efficiency of the Roth backdoor, you should have no other traditional IRA assets. When you convert money from your traditional IRA to a Roth IRA, the regulations require the Pro-Rata rule to determine how much of the conversion is taxable.
If you have a large traditional IRA balance, $5,500 or $6,500 will make up a small percentage of your overall balance. The percentage of deductible vs. non-deductible money determines how much of the money you convert into the Roth is taxable. If $5,500 is your intended transfer, and it represents only 10% of the total amount in your traditional IRA (the other 90% being made up of contributions from before-tax money), then per the pro-rata rule, 90% of your traditional IRA to Roth IRA transfer will be taxed!
There are a couple of ways around the pro rata rule, outlined here. One involves rolling all your deductible contributions and pretax earnings from your IRA into your employer’s 401(k), leaving just the non-deductible contributions in your IRA. Then you can do a tax-free conversion to a Roth. The other way is if you have a non-working spouse without a traditional IRA. You could make non-deductible contributions to a spousal IRA, and then he or she could then convert the money to a Roth tax free.
General rules and tax considerations
Because Roth IRA withdrawals are tax-free, contributions are made after taxes. If you are converting pretax monies from a traditional IRA to a Roth account, taxes will still be due at the end of the year.
Keep in mind that you can contribute up to $5,500 a year to the traditional and Roth IRAs if you are under 50 and up to $6,500 if you are over 50. Anything above these limits will be taxed at 6%.
Interest builds up while the money sits in a traditional IRA, but these earnings are taxable when you withdraw the money. The IRS allows only one rollover per year, but this rule doesn't apply to backdoor IRA conversions, so you can convert monies several times a year.
You can withdraw your contributions from a Roth IRA at any time without penalty or taxes. And you can withdraw both your contributions and the gains from a Roth IRA without any taxes or penalties after you turn 59½ years old, provided that the account is at least five years old. Otherwise, you will be subjected to the 10% tax penalty unless an exception applies (a first-time home purchase, for example). There won't be any taxes if the Roth IRA is inherited as long as the account is more than five years old.
A backdoor Roth IRA is worth considering if tax-free income during retirement is important to you and you make too much to contribute directly to a Roth. Whether you get one the usual way or go through the backdoor, Roth IRAs are an excellent option for younger investors at low tax rates and people with a high disposable income as they will reduce overall tax bills on capital gains in retirement.
Keith Clark is co-founder and managing partner of DWC - The 401k Experts, founded in 1999. He is the author of "The Defined Contribution Handbook" and was named one of the top five consultants in "Pension Management Magazine."
Clark is also an adjunct professor at the University of Minnesota's Carlson School of Management.