What is a backdoor Roth IRA and who can benefit from one?
If you earn too much money, you are not eligible to make a full Roth IRA contribution directly to a Roth IRA (over. However, there is a way around this. Some crafty accountants and financial advisors designed a strategy known as the backdoor Roth IRA. Using the Backdoor Roth IRA strategy can allow even very high income earners to save money in a Roth IRA, if you meet certain criteria.
A Backdoor Roth IRA: Is This Legal?
Great question. There used to be some debate around whether or not this strategy would stand-up to IRS scrutiny or if it consituted a step-transaction. Following the Tax Cuts and Jobs Act of 2017 the strategy appears to have received the blessing of Congress.
The Backdoor Roth IRA Strategy
In a nutshell, an individual opens and funds a Traditional IRA but does not take an income tax deduction on that contribution. This makes the contribution a “non-deductible” contribution. This is very important. A non-deductible contribution is your basis and will not be taxed on your basis when you convert it to a Roth IRA.
(Compliance Alert: This is not personalized financial or tax advice. It is general in nature. Speak to your CPA or financial planner before making any changes.)
What? I thought Roth conversions were taxable?
You’re right, a typical Roth conversion is taxable because you have taken a tax deduction on your original contribution. However, if you don’t take a tax-deduction on your tax return, your contribution (your basis) is not taxable when you convert it to a Roth IRA.
Ok, now what?
Next you convert your contribution from the Traditional IRA to a Roth IRA, and file a form 8606 detailing your non-deductible contribution(s) with your tax return. Your CPA can help you with the paperwork to make sure this is done efficiently and accurately.
That seems too easy.
You’re right. There are a number of tax potholes you must understand before you consider this strategy.
Backdoor Roth IRAs: An Inconclusive List of Things to Remember
#1 Make Sure You Have No Other Pre-tax IRAs
The IRS does not allow you to pick and choose which money you convert from a pre-tax account to a Roth in order to avoid taxation. If you had no other pre-tax IRAs and you made a non-deductible Traditional IRA contribution and converted it, that would be fine.
However, most people have old pre-tax IRAs lying around. If you had an old SEP IRA or a pre-tax Rollover IRA, the IRS would not allow you to simply select the new non-deductible IRA to convert. Instead you would have to give Uncle Sam a cut and convert the money on a pro-rata basis.
Think about it as coffee and cream. You can’t separate the cream from the coffee, you have to just take a little bit of each in every sip that you drink.
If you have any other pre-tax IRAs open on 12/31 you will owe taxes on your Roth conversion. Roll your old pre-tax IRAs into a 401(k) or 403(b) before implementing a Backdoor Roth IRA strategy.
Tax Trap #2: Assuming Your 401(k) Plan Will Accept Your Old IRA
You have to read your Summary Plan Description (don’t worry, we do this for you) to determine whether or not your 401(k) will accept Rollovers and whether or not they will accept your account type. For example, there are many 401(k)s who won’t accept SIMPLE IRAs as a rollover.
We’ve helped clients navigate through this situation but the key here is to make sure you are good to go before you dive in on this strategy or you could wind up paying more in income taxes.
Tax Trap #3 Converting Gains
If you wait too long to make the conversion or invest the money in the Traditional IRA while you wait to convert it, you will have to pay income taxes on any gains when you convert the account to a Roth IRA. You may want to wait for a statement to cut for your own tracking purposes but this is not technically necessary.
Tax Trap #4 You Must File Tax Form 8606
Form 8606 documents your basis in the non-deductible IRA in case the IRS ever decides to take a look at you. At Spark we provide clients with an online storage file so we can keep track of all of your old tax returns (and form 8606s).
Tax Trap #5 Not All IRAs Are Eligible
You can not convert a SIMPLE, SEP, or inherited IRA to a Roth IRA. Certain 457 plans are not eligible for conversion either.
Recap of the Backdoor Roth IRA
The Backdoor Roth IRA is a savvy way of saving more in a Roth account for high income earners but it’s not without its perils. This article is meant to help you at a high level but it does not consider every possibility and is not meant to be a comprehensive discussion on the strategy.
It is imperative you talk to a CPA or financial advisor before implementing any financial strategies. This is general advice and should not be relied upon to make any financial decision.
If you want personalized advice, book a call today.
Questions for Lauren?
Financial planner and advisor, Lauren Zangardi Haynes, CIMA®, CFP®, CEPA works with business owners and leaders in Richmond and Williamsburg, VA. She also works virtually with clients nationwide.
As a fiduciary, she offers comprehensive Fee-Only financial planning and investment advisory services so you can live your dreams with confidence.