As many of you know the Roth IRA is my favorite retirement account because of the tax-free growth and withdrawals it offers. In 2020, the adjusted gross income (AGI) phase out for contributing to a Roth IRA is $196,000 to $206,000 for married couples filing jointly. For singles and heads of household, the income phase-out range is $124,000 to $139,000. All of this means if you make over these numbers, you’re no longer eligible to contribute to a Roth IRA.
This is where the Backdoor Roth IRA comes into play. It will allow someone who isn’t eligible to contribute to a Roth directly due to the income restrictions the ability to still contribute to a Roth.
Here is how to contribute to a Roth IRA through a backdoor:
1) In 2020, you can contribute $6,000 ($7000 if you are over age 50) to a traditional IRA. You open a traditional IRA and contribute $6000 (of after-tax money).
2) You open a Roth IRA and then convert your $6000 traditional IRA to a Roth IRA. Keep in mind, a Roth has a 5-year rule which means you have to keep it open at least 5 years before you can use or withdraw your funds preferably after age 59 ½. (With a Backdoor Roth IRA, it’s deemed a conversion so you have access to your contributions after 5 years without a taxable event.)
There is a catch and it’s called the pro-rata rule. Unfortunately, if you have both pre-tax and after-tax funds in IRAs, the IRS will not let you designate what funds transfer into the Roth through a conversion. Ideally, you’d just move the money you already paid taxes on. Instead the IRS looks at the sum of all your IRA’s (traditional IRA’s, SEP IRA’s, SIMPLE IRA’s). For example, if only 20% of the funds in all your IRA’s is after-tax, then only 20% of your Roth conversion is going to be tax free.
Company sponsored plans are not included in pro-rata calculations and some allow you to roll IRAs into them. If you can, it is possible to avoid the pro-rata rule if you roll your IRA’s into a company sponsored plan such as your 401(k) or 403(b).
If you are a high earner and you’re not able to contribute directly into a Roth IRA then the Backdoor Roth IRA can work for you. All it takes is an extra step or two to put it in motion.
Who it works best for?
- You make over the income limits for contributing to a Roth IRA
- If you have little to no pre-tax IRA’s
- You can keep the money in your Roth for at least 5 years.
Who it might not be best for?
- You have a large amount of pre-tax IRA’s (consult your CPA to run the numbers for the pro-rata rule.)
- You might need the money within 5 years. (Example, you do a Backdoor Roth IRA at age 58. You’re going to have to keep the money in the Roth for at least 5 years so if you needed the funds at age 60, this would not be a benefit to you.)
The Backdoor Roth IRA is simply a legal loophole that allows you a work around to the current IRS rules. It works for some and doesn’t work for others. However, if you make enough money to not be able to do a normal Roth contribution, it’s worth looking into.
Live free my friends,