The Backdoor Roth IRA & How to Set One Up

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When you consider building your nest egg, Roth options can be extremely valuable. Specifically, when it comes to Roth IRAs, one of the greatest benefits is they allow qualified investors to enjoy tax-free withdrawals of their money. A backdoor Roth IRA allows people with high incomes to sidestep the Roth’s income limits.

Read More: Roth IRA vs. Roth 401k: How are They Different?

What Is a Backdoor Roth IRA?

A Backdoor Roth IRA essentially lets you convert your nondeductible traditional IRA contribution to a Roth IRA, even if your income is too high to make a Roth IRA contribution. If performed correctly, the Backdoor Roth Conversion does not have tax consequences.

An important consideration is your Modified Adjusted Gross Income (MAGI) and tax-filing status (single, married filing jointly, married filing separately). This will determine if you are eligible to contribute to a Roth IRA.

If you file taxes as a single person, your MAGI must be under $140,000 for tax year 2021 to contribute to a Roth IRA. (You can contribute fully only if your income is under $125,000. Those with income between $125,000-$140,000 can contribute incrementally less as their income increases.)
If you’re married and file jointly, your MAGI must be under $208,000 for tax year 2021. (You can contribute fully only if your combined income is under $198,000. Those with income between $198,000-$208,000 also have incrementally lower contribution thresholds.)

The maximum total annual contribution for all your IRAs combined is:

$6,000 if you’re under age 50
$7,000 if you’re age 50 or older

If your current MAGI exceeds the limit given your tax filing status, you may be able to leverage Backdoor Roth conversion for your retirement savings.

Are Backdoor Roth IRAs Allowed in 2021?

In September, House Democrats proposed several changes to tighten the rules around backdoor Roth IRAs. The legislation would prohibit individuals who earn over $400,000 per year from converting pre-tax retirement savings accounts to a Roth IRA. Most of the changes would begin in 2022.

If the new law is approved, both the traditional IRA contribution step and the Roth conversion must be completed by the end of 2021 in order to do a backdoor Roth IRA for tax-year 2021.

How to Create a Backdoor Roth IRA

To perform a Backdoor Roth Conversion, you can follow the below steps:

Make a nondeductible, traditional IRA contribution. Unlike a Roth IRA, the traditional IRA has no income ceiling for contributions.
Convert the nondeductible IRA contribution to your Roth IRA. If there are no earnings on the converted funds, then the conversion is a non-taxable event (unlike if you were to convert pre-tax IRA funds into a Roth, in which case you pay taxes on the converted amount at your current ordinary income rate).
Repeat annually, as long as this strategy remains appropriate for your financial situation.

It is encouraged you work with a tax professional and your financial advisor prior to executing a Backdoor Roth Conversion, as there may be some instances where you will need to pay taxes:

If you included pre-tax IRA assets in the conversion. If you deducted your Traditional IRA contributions and then decided to convert your traditional IRA to a Roth IRA, you’ll need to pay taxes on the pre-tax assets. When it comes time to file your tax return, be prepared to pay income tax on the pre-tax money you converted to a Roth.
If you have other pre-tax IRA assets remaining after your Backdoor Conversion. This is known as the Pro Rata rule, which we discuss below.

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Rules to Know

As with many financial vehicles, there are notable rules to keep in mind in order to avoid having the need to pay penalties.

Transfers

Keep in mind that the conversion needs to fall within one of the following options:

a rollover, where you receive funds from your IRA and deposit the money into the Roth account within 60 days
a trustee-to-trustee transfer, in which the IRA provider sends your funds directly to the Roth IRA provider
a “same trustee transfer,” in which the IRA to Roth accounts are with the same financial institution

The Pro Rata Rule

One of the most important rules relevant to the Backdoor Roth Conversion is the Pro Rata Rule.

The Pro Rata Rule is an IRS rule that determines what amount is subject (or not) to taxes when you convert IRA dollars from a Traditional IRA to a Roth IRA. To put it simply, if you attempt to convert after-tax Traditional IRA contributions to a Roth IRA, but there are existing pre-tax IRA dollars, you will be subject to taxation on a prorated basis.

When determining your tax bill on a conversion from a traditional IRA to a Roth IRA, the IRS is going to look at all of your IRA accounts combined. For example, if all of your IRAs combined consist of 80% pre-tax money and 20% after-tax money, that 80/20 ratio determines what percentage of the after-tax money you convert to a Roth is going to be taxable. For this specific example, no matter how much money you convert or which pre-tax IRA account you pull the money from, 80% of the amount you convert to the Roth will be taxable. The IRS applies the Pro Rata Rule to your total IRA balance at year-end, not at the time of conversion.

The 5-Year Rule

Don’t forget the 5-year rule, which dictates a five-year waiting period before earnings or converted IRA funds can be withdrawn from the account. To withdraw earnings from a Roth IRA without owing taxes or penalties, you must be at least 59½ years old and have held the account for at least five tax years. If funds are withdrawn earlier, you may have to pay taxes on any earnings and potentially will incur a 10% penalty unless you are age 59 ½ or older.

Is a Backdoor Roth IRA Worth It?

Depending on several factors, the Backdoor Roth Conversion may not fit everyone’s financial strategies and goals.

You may not need a Backdoor Roth Conversion if you are able to meet your savings goals with the maximum retirement limit through your workplace retirement account and are not planning on additional retirement savings.
If you already have pre-tax money in a traditional IRA, because of the pro rata rule, it may not end up being advantageous from a tax perspective to convert.
It’s worth noting that inherited IRAs are not included in the pro rata calculation.
You should be willing to keep the funds in the newly created Roth IRA for at least five years before withdrawing the money.
You may want to keep the money in the traditional IRA if you are in a high tax bracket now and expect to be in a lower tax bracket upon retirement.
If you plan to relocate to a lower income tax state or a state where there are no income taxes.

Backdoor Roth IRAs are worth considering for your retirement savings, especially if you are a high income earner. A Backdoor Roth conversion can be something to consider if:

You’ve already maxed out other retirement savings options
Are willing to leave the money in the Roth for at least five years (ideally longer!)
Do not have other pre-tax IRA assets

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