In 2010 the income limits on IRA conversions were lifted. This put Roth IRA investments within reach of higher-income individuals previously shut out of Roth IRA contributions because they made too much income to make a direct Roth IRA contribuition. How does a high income taxpayer make a Roth contribution?
Backdoor Roth IRA
The Backdoor Roth IRA contribution maneuver is simple.
A taxpayer who earns too much to make a Roth IRA contribution contributes to a Traditional Non-Deductible IRA, which is available regardless of income level. Immediately thereafter the taxpayer converts it to a Roth IRA since there currently are no income limits on Roth IRA conversions. Since the "Traditional Non-Deductible IRA" was not deducted from the taxpayers income, theoretically, there is no tax due on the conversion. The Keyword here is theoretically.
A Backdoor Roth IRA is a conversion of a Traditional IRA assets to a Roth IRA. Currently, anyone can convert money that they have put into a Traditional IRA to a Roth IRA, no matter how much income they earn. What’s more, they can also roll as much money as they want from an existing Traditional IRA into a Roth IRA. In other words, if the Traditional IRA has more than the yearly contribution limits on IRAs, you can roll over that larger sum into a Roth at one time.
Keep in mind: This is not a tax dodge. You will need to pay taxes on any money in your Traditional IRA that hasn't already been taxed. The funds that you convert to a Roth IRA will most likely count as income, which could kick you into a higher tax bracket in the year you do the conversion.
On the other hand, if your income happens to be unusually low in a particular year—perhaps you had a gap in employment—you could take advantage of that situation by making the Roth conversion then. Timing is important. Carefully calculate the tax implications of a Roth IRA conversion before you decide.
You can do a backdoor Roth IRA in one of two ways.
The first method is to contribute money to an existing Traditional IRA, sell shares, and then roll over the money to a Roth IRA account.
The second method is not a true Backdoor Roth. You can convert an entire Traditional IRA account to a Roth IRA account. Your bank or brokerage should be able to help you with the mechanics. Your Traditional IRA doesn’t have to be new. You can roll over existing Traditional IRA money—or an old Traditional IRA account—into a Roth.
If you convert a Traditional IRA—money on which you have already received an income tax deduction—to a Roth IRA, you will owe taxes on the entire amount you convert. If you contribute $5,500 to a Traditional IRA and then convert the money to a Roth IRA, you will owe taxes on the $5,500, plus on whatever money it earns between the time you contributed to the Traditional IRA and when you converted it to a Roth IRA. If you have saved $500,000 in a Traditional IRA, and convert the entire $500,000 to a Roth, you will owe taxes on the $500,000.
On the other hand, you may have made non-deductible contributions to a Traditional IRA, money that you contributed after you had paid taxes on it. That can happen 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 You can take that post-tax Traditional IRA money and convert it to a Roth IRA without another tax bill because you’ve paid the tax already.
Are you converting your entire retirement portfolio to a Roth, or keeping some money in Traditional IRAs, SEPs or SIMPLE IRAs?
If you convert some money to a Roth IRA and keep some money in other kinds of IRAs, you don’t owe taxes simply on the converted amount. Instead, you owe taxes based on the proportion of your IRA money overall that is after-tax and before tax.
To figure out how the pro-rata rule applies to you, calculate how much money in your IRA accounts is pre-tax and how much is after tax. Treat all of your IRAs like one big IRA for this purpose. Say you have a total of $100,000 in all of your accounts, and $10,000 of it is money you put in after taxes. You will owe taxes on 90% of the money you convert to a Roth.
What exactly is a Backdoor Roth IRA?
Assuming there are no other IRA assets, the only taxes due would be on the appreciation of the Traditional IRA from the time it was opened until the time it was converted to a Roth IRA. Here's where it could get complicated:
Contact Us if you wish to discuss the Backdoor Roth IRA contribution.