A traditional IRA is typically made with pre-tax dollars, grows tax-deferred and will be taxed when withdrawn at retirement. A Roth IRA is funded with after-tax dollars, grows tax deferred but qualified withdrawals are not taxable when withdrawn. Because there are income limitations for traditional IRAs to be deductible and for Roth IRAs, many higher income investors may be missing out on a completely legal but nifty strategy, a backdoor Roth IRA.
You can do a backdoor Roth IRA in one of two ways. First, you can contribute money to an existing traditional IRA, and then roll over that portion of money to a Roth IRA account. Secondly, you can convert an entire traditional IRA account to a Roth IRA account. Then, you can roll over existing traditional IRA money—or an old traditional IRA account—into a Roth.
Here's the kicker: In 2019, if your modified adjusted gross income (MAGI) is $137,000 (single) or $203,000 (married filing jointly or qualifying widow[er]), you may not contribute to a Roth IRA. But, these limits do not apply to Roth IRA backdoor conversions.
Starting in 2019, you may contribute only $6,000 ($7,000, if you are age 50 or over) to a Roth IRA. Once again, with a backdoor Roth IRA conversion, these limits do not apply.
If your income is beyond these limits—or if you want to convert more to a Roth than the allowed contribution limit within one year—a backdoor Roth IRA is the only way to do so.
However, suppose you made non-deductible contributions to a traditional IRA, money that you contributed after you had paid taxes on it. Why would I do that? Only if you want to contribute to a traditional IRA but you (or your spouse, if you’re married) have a 401(k) or similar plan at work and you’re income level prevents you from deducting your traditional IRA contribution. You can take that post-tax traditional IRA money and convert it to a Roth IRA potentially without another tax bill because you’ve paid the tax already.
A backdoor Roth may be a very smart planning strategy for high-earning households, because it allows you to max-out a Roth IRA even if you are above the income limitations. There are no income limitations for making non-deductible IRA contributions, and everyone is permitted to do one Roth IRA conversion a year.
For this to work, you must have w-2 earned income like wages or self-employment income to be able to make a non-deductible IRA contribution. Without that there can be no back door because you never came in the front door. There are numerous tax considerations so its recommended to obtain advise from a CFP® or tax professional before making a Roth conversion.
This article is for informational purposes only. This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice as individual situations will vary. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional. Withdrawals from the account may be tax free, as long as they are considered qualified. Limitations and restrictions may apply. Withdrawals prior to age 59 ½ may result in a 10% IRS penalty tax. Future tax laws can change at any time and may impact the benefits of Roth IRAs. Their tax treatment may change. Roth IRA account owners should consider the potential tax ramifications, age and contribution limits in regards to funding a Roth IRA. Unless certain criteria are met, Roth IRA owners must be 59½ or older and have held the IRA for five years before tax-free withdrawals are permitted. Additionally, each converted amount may be subject to its own five-year holding period. Converting a traditional IRA into a Roth IRA has tax implications. Investors should consult a tax advisor before deciding to do a conversion.