The Backdoor Roth IRA: Converting Non-Deductible IRA Contributions Into a Roth IRA
By Todd I. Youngdahl, CFP®
Roth IRAs remain great savings vehicles for many reasons. A Roth IRA can be a tax-free income source in retirement. They don’t have required minimum distributions when you reach age 72 as with most other tax-advantaged retirement plans. And, Roth IRAs have flexible inheritance rules that will benefit your children and grandchildren.
The only problem with Roth IRAs is that you may not be eligible for one. You likely make too much money. For 2021, you are ineligible to contribute the maximum contribution directly to a Roth IRA if you are single with an adjusted gross income (AGI) over $140,000 or a married couple with an AGI over $208,000.
Why tout the benefits of a Roth IRA to people who may be unable to contribute directly to one? Another contribution path exists. It is called a Backdoor Roth IRA which offers an alternative way to get investment dollars into a Roth IRA.
High-income earners can put their investment dollars into a Roth IRA by converting a traditional IRA funded with non-deductible contributions to a Roth IRA. This is commonly called a Backdoor Roth IRA. With the non-deductible contributions in your IRA, you won’t have to pay any taxes on conversion. That’s because you’ve already paid the taxes on that money. So, you can convert non-deductible IRA contributions into a Roth account rather easily and painlessly.
How it works:
- Open and make contributions to a traditional IRA as a non-deductible contribution
- Convert your account to a Roth IRA. Your financial advisor or IRA administrator can help you with the paperwork to do this.
- You will only pay taxes on any gains on the non-deductible IRA contribution that gets converted.
In addition to the process above, there is another way to get dollars into a Roth IRA when you’re income is too high to contribute directly. If you’re Employer sponsored retirement plan’s (401k, 403b,etc) documents allow for it, you can make after-tax contributions to the plan and subsequently can be rolled over to a Roth IRA.
Things to Watch Out For With Backdoor Roth IRAs
What happens if you have both pre-tax and non-deductible after-tax contributions in Traditional or Rollover IRAs? Unfortunately, you cannot choose to only transfer the after-tax contributions. The IRS follows the pro rata rule for IRA conversions using percentages to calculate the tax basis.
For example, if 60% of all of your combined traditional IRA contributions were made pre-tax and 40% were made after-tax, then those are percentages used to determine the tax basis of the conversion. No matter how much you convert or which specific IRAs it comes out of, 60% of the funds will be taxable and 40% will be considered tax-free.
Because of the pro rata rule, the Backdoor Roth IRA strategy tends to work best if you have no other IRA’s with pre-tax dollars in addition to the Traditional IRA funded with non-deductible contributions.
You should also be aware of how your traditional IRA custodian transfers the money. If the money gets sent to you and it takes longer than 60 days to get it into a Roth IRA, it will be considered a withdrawal and subject to taxes and penalties.
The easiest way to avoid these penalties is to open your Roth IRA with the same custodian as your traditional IRA. In that case, a “same trustee transfer” can be made where the money never even leaves that institution.
If you have multiple traditional IRAs with multiple administrators, you can do a “trustee to trustee” transfer to a Roth IRA which eliminates the risk of the transfer being considered a withdrawal.
The final, and riskiest, way to transfer funds is for you to act as the middleman. If you chose this method, you need to be very careful to get the traditional IRA funds into the new Roth IRA account within the specified time period. Also, your traditional IRA administrator may withhold taxes on the distribution. Even if they withhold 20% and send you 80%, you are still responsible for getting 100% of the account value into the new account or you will face penalties.
Backdoor Roth conversions are an excellent financial planning tool, but they can get complicated. The taxation of backdoor Roth conversions can be confusing and push you into a higher tax bracket if not properly planned. And, if the transfer isn’t done correctly, you could end up owing taxes and penalties.
It’s always a good idea to work with an experienced financial professional when attempting a backdoor Roth conversion. If you want help executing a Backdoor Roth IRA, call us at 703.584.2700 or schedule a meeting with Todd.
About Washington Wealth Advisors
Washington Wealth Advisors is a Fee-Only registered investment advisory firm serving busy families, executives, women building wealth and small business owners. We provide Wealth Advisory Services – financial planning coupled with asset management – guided by a personalized investment strategy based on each client’s unique goals. Our unbiased advice, independent approach and proactive investment management help to support our client’s overall financial peace of mind.