Recently, I put together a post: What If You Don’t Qualify for a Roth IRA? I got some fantastic feedback from readers, but many of them had the same question that kept coming up:
What about a backdoor Roth IRA? Is that an option I should look at, too?
So, today we’re going to extend the original post to a “part two” specifically to cover what a backdoor Roth IRA is, whether or not it’s legal, how it’s created, and what the tax consequences or financial benefits are.
What is a Backdoor Roth IRA?
A backdoor Roth IRA is the conversion of nondeductible, after-tax contributions to a Traditional IRA to a Roth IRA. Few people realize that after-tax contributions to a Traditional IRA are even possible – because it’s so often viewed as a pre-tax contribution account that lowers your current taxable income.
That being said, anyone can convert after-tax money that they’ve been saving in a Traditional IRA to a Roth IRA – and there are no income restrictions. This helps savers conveniently side-step the income restrictions that come along with a Roth IRA.
In 2019, if your modified adjusted gross income (MAGI) is:
- $137,000 (single)
- $203,000 (married filing jointly or a qualifying widower)
you aren’t allowed to contribute to a Roth IRA.
However, for many people who are proactively saving for retirement, contributing to a retirement savings account (a Roth IRA) with after-tax funds, then not having to have those funds taxed during retirement, is very appealing.
This is especially true for younger savers who have a longer timeline before they retire and expect to retire in a higher tax bracket than the one they’re currently in, and for savers who may be closer to retirement but still want to reap the benefits of tax-free retirement savings growth in a Roth IRA.
Is It Legal? And Will I Owe Taxes?
Yes, a Roth IRA is legal. However, it’s important to remember that this isn’t a way to completely skip out on your taxes. Money that’s been converted from a Traditional IRA to a Roth IRA will still be taxed at your current income tax rate. This could bump you up into a higher tax bracket during the year that you undergo the conversion.
However, when you’re contributing a small sum to a Traditional IRA each year and planning to convert it to a Roth IRA – this point becomes moot. The income taxes you’ll pay on capital gains earned from $6,000 of after-tax contributions, for example, are relatively minimal. The after-tax growth you’ll experience on those funds in a Roth IRA is definitely worth the small amount you may owe in capital gains taxes after your conversion.
How Do You Create a “Backdoor” Roth IRA?
To create a “backdoor” Roth IRA, you follow the following steps:
- You make a non-deductible contribution of after-tax funds to a Traditional IRA.
- You convert those funds to a Roth IRA – and pay whatever taxes you may owe on the gains earned from those contributions.
- You watch your savings grow tax-free until you retire.
Did you know that you can do this conversion process regularly – sometimes even annually – with no penalties? There’s no one-time limit, and this opens up the ability for you to contribute non-deductible funds to a Roth IRA – even if your MAGI disqualifies you from contributing to one directly.
This concept is truly the “backdoor” part of the Traditional → Roth IRA conversion. Because your funds won’t really grow that much over the course of the year, any taxes you’d owe on the capital gains earned on your contributions to a Traditional IRA would be minimal. Then, when you convert the funds to a Roth IRA, they can continue to grow tax-free until you retire.
For many people, this is an ideal situation. They get all the benefits of tax-free growth, and the process of converting after-tax contributions from a Traditional → Roth IRA is relatively straightforward – making the process tough to shake a stick at.
Why Would I Want a Roth IRA?
Roth IRAs aren’t necessarily the end-all-be-all retirement savings vehicle. This is, for the most part, because their contribution limits are relatively small in comparison to a 401k, or other traditional retirement savings route that you might take. For 2019, you can only contribute $6,000 to your Roth IRA. And if you make over the specified MAGA (listed above), you can’t contribute at all.
So, what purpose does a Roth IRA serve?
When you create a backdoor Roth IRA, you’re allowing all of the funds you’ve accumulated to continue growing tax-free until you retire. Contributing after-tax funds to your Traditional IRA with the intent to convert them to a Roth at the end of the year may make sense for your unique financial situation.
You’re freeing yourself up to continue growing your retirement savings tax-free without having to pay a mass sum of money in taxes on pre-tax contributions that you’re “rolling over” into a Roth IRA.
What If You Have a Pre-Existing Traditional IRA?
Keep in mind that if you have one or more existing Traditional IRAs with contributions that have grown over time, they fall under the “pro-rata” rule. So, if you convert a recent after-tax contribution to a Roth IRA, you’ll owe taxes upon conversion at a pro-rated rate. This means that if you have a significant amount of money already in your Traditional IRA, you could be looking at a bigger tax event than if you were to start fresh and begin converting funds once a year. Speaking with a financial planner or a tax professional can help you to determine what, exactly, you can expect from your taxes when doing a Backdoor Roth IRA.
Have questions? Feel free to schedule a consultation with me today. Deciphering whether or not a backdoor Roth IRA is in your best interest can be challenging, and having a financial planner walk you through how it fits into your larger financial strategy can be a huge help.