A Roth IRA is the ultimate retirement vehicle, as it allows you to contribute post-tax dollars to a retirement account. That means a Roth IRA grows tax-free and is withdrawn tax-free since you've paid taxes on the money upfront. That sounds like a good deal - unless you bump up against income barriers. If you make too much money, you might find yourself blocked from contributing to a Roth IRA - that is, unless you go through the backdoor.
Slipping into a Roth IRA
For 2016, only individuals making less than $132,000 per year or a married couple making less than $194,000 per year can contribute directly to a Roth IRA. Thus, higher income earners are effectively locked out from contributing directly to a Roth IRA.
However, in 2010, income restrictions were removed from Roth conversions, which opened the "back door" to allow anyone to contribute to a Roth IRA, either directly or indirectly.
If you exceed the Roth IRA income limits, you can perform the below steps to contribute to a Roth IRA:
1. Open a traditional IRA, if you don't have one already.
2. Make a nondeductible contribution to your traditional IRA, up to the limit of $5,500 per year for those under 50 and $6,500 per year for those 50 and over.
3. Shortly thereafter, convert your nondeductible contribution from your traditional IRA to your Roth IRA.
Upon your conversion, you'll only owe taxes on the growth of your nondeductible investment from the time when you initially made your contribution to your traditional IRA to when you ultimately converted it to your Roth IRA. Since this is typically a very short amount of time, your tax liability from the conversion should be minimal.
Matthew Heaney, a 51-year-old software engineer based in San Jose, has been utilizing the backdoor Roth IRA strategy since he heard about it five years ago. "Because the money grows and is withdrawn tax-free, what you see is what you get," he said. "During retirement, I'll be able to make withdrawals from my Roth IRA without having to worry about paying taxes or how those withdrawals will affect my taxable income."
Financial advisors also swear by the Roth. Jeff Jones, a Certified Financial Planner with Cypress Financial Planning in Woodbury, N.J., leans on Roth IRAs extensively in his practice. "After ensuring company 401(k) matches are being maximized and high interest debt is eliminated, I make sure every client utilizes a Roth IRA to the fullest extent."
Pre-tax 401(k)s and traditional IRAs, on the other hand, allow you to invest pre-tax monies into a retirement account that grows tax-free. When you begin taking withdrawals from these accounts, you'll be taxed on the entire amount of your withdrawal (contribution and growth) at your ordinary income tax level.
This additional tax diversification could be a very valuable benefit, especially if you're able to isolate tax inefficient investments, such as REITs, into your Roth IRA. That could help those planning for retirement save a bundle in taxes.
As an added bonus, unlike traditional IRAs, Roth IRAs don't have the required minimum distributions that take effect as an account holder nears age 70.5. That means, a Roth IRA account holder has the flexibility to let their money grow or take it out for use as needed.
Beware of the Pro-Rata Rule
The backdoor Roth IRA strategy works best when you do not have any outstanding traditional, SEP, or simple IRAs. If you do have any of these accounts, you should consider rolling the monies into your current 401(k) plan. If that's not an option, you should think twice before doing the backdoor Roth IRA strategy.
The reason the strategy becomes a little hairy when you have existing IRAs outstanding is the IRS forces you to convert monies on a pro-rata basis rather than allowing you to select specific monies to convert.
For example, let's say you have $15,000 in deductible contributions in a traditional IRA. You make a nondeductible contribution of $5,000 into your traditional IRA with the goal of converting it into a Roth IRA. Not so fast. Unfortunately, because of the pro-rata rule, in this situation, if you converted $5,000 into a Roth IRA, you would owe taxes on $3,750 of the $5,000 (at your ordinary income tax level). This is because 75% of your IRA is made up of deductible contributions ($15,000/$20,000 = 75%) while 25% is nondeductible contributions ($5,000/$20,000 = 25%). When you make the conversion, the IRS assumes the monies are converted on a "pro-rata basis." As a result, 75% of the $5,000 you converted is assumed to be made up of deductible contributions, and thus, taxable.
When employing the backdoor Roth IRA strategy with clients, Jones of Cypress Financial Planning takes care to heed these necessary caveats. "I first take steps to ensure there are no outstanding pre-tax IRA funds due to the pro-rata rule," he said. "Then, each spring, I work with clients to max out their Roth IRA with no adverse tax consequence."
The backdoor Roth IRA strategy is a great tool to allow high-income earners to contribute up to $5,500 a year ($6,500 for those 50 and over) to a Roth IRA. With that said, the strategy works best if you do not have any traditional, SEP, or simple IRAs outstanding. Before proceeding with the strategy, make sure to roll over any IRAs to an existing 401(k) to make the conversion as clean as possible and to ensure minimal tax liability.