Updated on 07/09/2019
Backdoor Roth IRAs have increasingly become more popular over the last few years. The following post is the first in a two part series of blog posts that are dedicated to helping readers understand what exactly a Backdoor Roth IRA strategy entails, what are the pitfalls to avoid, and what type of investors would benefit from this strategy.
Part 1 – Introduction to Backdoor Roth IRAs
Roth IRAs have become an increasingly popular retirement savings tool for Americans, and rightfully so. The accounts grow tax deferred and, if held until 59 ½, the growth in the accounts can be withdrawn at a 0% income tax rate. Also, unlike its Traditional IRA cousin, owners of Roth IRA accounts do not have to make Required Minimum Distributions (RMDs) once they have reached age 70 ½, allowing the accounts to continue to grow income tax-free if the money is not needed to provide retirement income for the retiree. Contributions to a Roth (not the growth in the account, but just the contributions) can also be withdrawn before age 59 ½, if needed, without incurring a penalty (please note that contributions that are from an IRA conversion need to remain in the Roth account at least 5 tax years to satisfy the Roth’s five year rules and avoid penalty). A similar withdrawal in a Traditional IRA would result in the amount withdrawn being taxed as ordinary income and assessed a 10% penalty.
Unfortunately, for those with higher Modified Adjusted Gross Income (MAGI), contributing directly to a Roth IRA may not be an option. For tax year 2019, a married couple, filing jointly, starts seeing Roth contributions begin to phase out once their MAGI is above $193,000 and any couple who has a MAGI of $203,000+ is not allowed to make a direct contribution to a Roth at all for that year. Similar income limits apply to singles as well; phase out of Roth contributions begin at MAGI of $122,000 and anyone with MAGI of $137,000+ is ineligible to make direct contributions to a Roth (It is important to note that this is based on MAGI for a given year, if in 2020 a person sees their MAGI drop back below this threshold, they are allowed to make direct contributions once again).
For those of you that are above these income thresholds and are bummed that you cannot contribute to a Roth IRA, never fear! There is currently a loophole that allows individuals above these income thresholds to still contribute to a Roth IRA, but there are just a few extra steps required. These few extra steps separate a normal Roth contribution from a backdoor Roth conversion.
So what is a Backdoor Roth IRA?
Under the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA), beginning in tax year 2010, the MAGI limitations that were on Roth conversions from a Traditional IRA were lifted. Thus, regardless of one’s income, a person could convert all or a portion of their Traditional IRA to a Roth IRA (note that this is strictly regarding Roth CONVERSIONS, as Roth CONTRIBUTIONS still have the MAGI income restriction listed above). This development created a loophole that has led to the popularity of the “backdoor Roth IRA” strategy.
Essentially how the “backdoor Roth IRA” works is an individual, who is above the MAGI income limits, makes a nondeductible contribution to a traditional IRA account up to the annual contribution limits (for 2019, each person can contribute up to $6,000 in an IRA account, thus a single person can contribute up to $6,000 a year, a married couple can each contribute $6,000 for a cumulative total of $12,000 a year). After the contribution has been in the IRA for a period of time (more on this in part 2, but generally a year or less), the individual may convert the traditional IRA into a Roth IRA. As the current tax rules are written, individuals who are above the MAGI income limits could continue to repeat this process each year and essentially work around the Roth income restrictions by making nondeductible IRA contributions then converting the traditional IRA to a Roth. Thus, while high income individuals are not technically allowed to directly contribute to a Roth IRA, there is a "backdoor" that allows them to contribute to a Roth IRA like everyone else.
It seems fairly straight forward and could be a good option for some, but there are a few important caveats to consider before initiating a “backdoor Roth IRA.” In part two of this series, we will look at the pitfalls that some individuals fall into when initiating a backdoor Roth IRA conversion and how to avoid these issues.
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Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Daniel Patterson, and all rights are reserved. Read the full disclaimer here.
