How To Complete a Backdoor Roth IRA Contribution and What to Watch Out For.
When Congress eliminated the income limitation for Roth conversions, while leaving in place the income limitation for Roth contributions, they made an interesting choice.
Under the current rules, you cannot contribute to a Roth IRA if your income is over the Roth contribution limit (currently $117,000 for singles, and $184,000 for married couples). By completing a contribution to a Traditional IRA, then converting the funds from the Traditional IRA to a Roth IRA, you are effectively accomplishing a similar result.
This process has become known as a Backdoor Roth IRA contribution.
Even though this language sounds shady, like you’re doing something sneaky that the government doesn’t know about by calling it a ‘backdoor’ contribution, I can assure you, this would have been so obvious to Congress, one could argue that they intentionally left this technique open.
How Does It Work?
There are a couple scenarios where you would use this technique. One where you are able to deduct a traditional IRA contribution, and one where you’re not.
One caveat to this is if you’re over 70.5 years old. While there’s no age limit to Roth IRA’s there is an age limit to contribute to a traditional IRA so once you reach 70.5, you either enter through the front door to a Roth IRA account or not at all.
How can you make a deductible contribution to a traditional IRA but your income is too high to contribute directly to a Roth IRA?
Here’s where that might happen.
Simply, if you don’t have or participate in another employer plan like a 401k.
Since you lose the ability to deduct a traditional IRA contribution at a lower income level than the phase-out for Roth IRA contribution, if you participate in an employer plan, this version doesn’t apply.
If you are able to deduct your contribution to a traditional IRA, then convert to a Roth, it would be perfectly acceptable to do this. You would come out in basically the same place as if you were able to contribute directly to the Roth.
Another scenario where this could be a possibility is if you’re in at least the 28% tax bracket. Most people think when you're in the 28% or above tax bracket, it always makes more sense to go traditional IRA. If you’ve read my previous blog post on the topic, you’ll know this isn’t always the case.
The best scenario to use the backdoor Roth technique is when you don’t have an existing traditional Roth IRA. All you have to do is create a traditional IRA, make a non-deductible contribution, then simply convert it to a Roth.
What I usually recommend is just putting your contribution in the traditional IRA into a money market fund and then after converting it to a Roth IRA, select your investment allocations. The reason I recommend just putting your contribution in a money market is because if your contribution were to increase in value, you would have to pay taxes on that part of the contribution.
If you already own another Traditional IRA you have to be careful.
If you already have another traditional IRA, you have to be concerned about what’s called the aggregation rule.
What this means is that, whether it’s a regular withdrawal or conversion, you determine your tax consequences as if they were one big IRA.
This means you may have to pay tax on the Roth conversion if you use the backdoor method, even if this brand new account you opened has never had any deductible contributions or investment earnings.
If you already have a traditional IRA and you want to add new money to a non-deductible traditional IRA and do the Roth conversion as we’re speaking of here, I would recommend you see your financial planner or tax professional to make sure you consider the tax implications.
You can potentially avoid this by isolating the IRA basis with an IRA to 401k rollover, but this is out of the scope of this article.
While there is no required waiting period to convert the money you put into a traditional IRA when converting to a Roth, I would recommend waiting a day to confirm the transaction was settled before converting. This will just keep the IRS happy in case they were to ask about the contribution with your income above the set limits. You want to make sure you can demonstrate this process was done in two separate transactions. If you cannot, the IRS may say that the money was a non-permitted contribution to the Roth account.
Another caveat to be aware of is that unlike normal Roth contributions which can be taken out anytime, without tax or penalty, money that is converted in the backdoor manner has different rules.
If any part of the conversion was taxable, then the withdrawal of those exact dollars before age 59.5 could lead to a 10% penalty unless they sat in the Roth at least 5 years before you pull them out.
Do you have to worry about the Backdoor Roth IRA contribution being illegal at some point?
While I’m not a lawyer, this is such an obvious loophole to the tax writers many prominent people studying this field would say it could have been intentional.
On top of that, most decisions by Congress are never retrospective so while they may change this in the future, for now, I think you’re safe.
If you are going to contribute to a non-deductible IRA please make sure to file form 8606 with the IRS here.
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