Earning a higher income may seem like the key to a more comfortable retirement but it can actually be a barrier to sone kinds of tax-advantaged retirement savings. That’s because a larger salary can shut you out of contributing to a Roth individual retirement account (IRA). For 2018, Roth IRA contributions are phased out for single filers with a modified adjusted gross income (MAGI) of $135,000 or more and married couples filing jointly whose MAGI exceeds $199,000.
A Roth IRA allows for tax-free qualified distributions in retirement, which may be invaluable if you anticipate landing in a high tax bracket when you retire. Fortunately, there is an available solution to the Roth IRA roadblock for affluent taxpayers: a backdoor Roth IRA.
How a Backdoor Roth IRA Works
In terms of the mechanics of a backdoor Roth, the first step is making contributions to a nondeductible IRA. This refers to a traditional IRA whose contributions are not eligible for a tax deduction, based on the saver’s income, filing status and coverage by an employer’s retirement plan.
Once the nondeductible IRA is funded, the next step is converting that IRA to a Roth. The conversion can be completed using an existing Roth account, or you may open a new Roth IRA if you don’t have one. The easiest way to execute a conversion is via a trustee-to-trustee transfer. The financial institution holding your nondeductible IRA contributions transfers them directly to the institution that holds your Roth IRA on your behalf. The conversion is reported on IRS Form 8606 when you file your taxes.
After the conversion is complete, the money in your Roth IRA becomes subject to Roth IRA distribution rules. The primary benefit to you is that any future earnings from investments in your account would not be subject to taxes when you (or your heirs) withdraw them from the account. In addition, your Roth IRA wouldn’t be subject to required minimum distribution rules. With a traditional IRA, you’d be required to begin taking minimum distributions from your account beginning at age 70½, or face a hefty tax penalty.
The Catch: The Roth Conversion Tax Bite
While converting to a Roth can minimize your tax liability when you tap your assets in retirement, you won’t be able to avoid taxes completely. Any untaxed amounts in your traditional IRA are taxed at the time the conversion is completed. This includes both pre-tax conversions and investment gains. If you’re in a higher tax bracket, a conversion could add significantly to your tax bill in the year when you make the conversion.
Using nondeductible traditional IRA funds can simplify the process, since these contributions are treated as after-tax dollars for conversion purposes. Taxation of a backdoor Roth can become more complicated, however, when your traditional IRA conversion includes both deductible and nondeductible amounts.
In this scenario, the IRS requires you to follow the pro-rata rule, which treats all of your IRAs as one collective IRA. If you’re completing a backdoor Roth IRA conversion using deductible and nondeductible traditional IRA money, the amount of your conversion that’s subject to tax is pro-rated across your total IRA balance. Essentially, this requires you to pay tax on the pre-tax part of your IRA when you convert.
Failing to understand which type of contributions your traditional IRA holds can result in an unpleasant tax surprise when you convert. The IRS does offer a work-around, however. If your employer allows it, you may be able to roll the pre-tax part of your traditional IRA contributions into your 401(k), leaving only the nondeductible portion behind for the conversion.
When Does a Backdoor Roth Make Sense?
A backdoor Roth IRA may be appealing if you’ve been blocked from contributing to a Roth because of your income. But it’s important to consider how it fits as part of your larger retirement strategy before making a move.
Take a look at your retirement timeline. If you’re close to your target retirement date, you may find that the conversion means that you will have paid taxes on a big chunk of retirement contributions and earnings from your traditional IRA and not be left with much pre-retirement time to enjoy tax-free growth in your Roth. If you'd just left the money alone until required minimum distributions at age 70½, you wouldn't have had to pay any taxes on it until then. And your annual RMD would likely have been significantly less than the amount of money you converted to the Roth and cost less in taxes.
Your timeline for using the funds in a backdoor Roth IRA also matters in a different way. The IRS imposes the same five-year rule on IRA conversions as on regular Roth IRAs. That means your Roth must be open for at least five years before you can withdraw funds from your account without a penalty. If you tap into the money sooner, you may face a 10% early withdrawal penalty if you’re under age 59½. If you’re over 59½, the 10% tax wouldn’t apply but the five-year rule is still in effect for earnings made before the five-year period is up. Those would be subject to income tax. You could, however, withdraw the original amount that was converted without owing income tax on earnings or a penalty.
The Bottom Line
A backdoor Roth IRA can help high-income earners plan for retirement while enjoying some important tax advantages. While the conversion itself isn’t difficult, untangling the tax issues associated with the process can be. Weighing the pros and cons with a financial advisor can help you decide if a backdoor Roth is the right move for you.