Personal Finance

Do you make too much for Roth IRA Contributions? Consider a Backdoor Roth!

There are many clients who would like to make Roth IRA contributions, but their income exceeds the applicable income limits. Clients who earn too much money (see chart below) aren’t allowed to open Roth IRAs under current IRS rules.

This puts out of reach one of the best features of a Roth IRA, the ability to maximize tax-free growth even after age 70½, because Roth IRAs do not require minimum distributions (RMDs). So if you don’t need income from your Roth IRA your balance continues to grow tax-free until it passes to your heirs.

Enter the Backdoor Roth, a work-around for those who earn more income than the current limits to establish a Roth IRA. With a Backdoor Roth, you first make a contribution to a Traditional IRA and then convert it to a Roth IRA.

What then is a “Backdoor Roth”?

A Backdoor Roth is a conversion of 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. You can also roll as much money as you want from a Traditional IRA into a Roth IRA, exceeding the contribution limits on IRAs. Therefore, investors can contribute through the Backdoor by making a nondeductible traditional IRA contribution and then converting to a Roth IRA. This allows you to avoid both Roth IRA income limits and Roth IRA contribution limits.

Example: Ned would like to make a Roth IRA contribution, but he is above his applicable income limit, so he is utilizing the Backdoor Roth IRA strategy. If Ned contributes $5,500 to his traditional IRA, he will have no deduction and his contribution will go in as after-tax funds. A month later, when his IRA account has risen to $5,600, Ned converts his traditional IRA to a Roth IRA. Since $5,500 of the $5,600 converted consists of after-tax dollars, only the $100 of gain will be taxable upon conversion. Thus, Ned will have paid tax on a total of $5,600, the entire balance of his Roth IRA at that point.

Looking at it from a tax standpoint, this strategy works best if you don’t have other traditional, deductible IRA assets, because if you do, part of the conversion would be subject to income tax.

For Example: Jan has $190,000 in her traditional IRA, all of which is pre-tax. If Jan makes a $10,000 nondeductible (after-tax) contribution to a traditional IRA, the total IRA balance will be $200,000, $10,000 of which will be after-tax. Thus, only 5% ($10,000 / $200,000 = 5%) of her Roth IRA conversion will be tax-free. If Jan converts $10,000 from her traditional IRA to a Roth IRA after making her nondeductible contribution, just $500 would be tax free ($10,000 x 5%), while the remaining $9,500 ($10,000 – $5,000 = $9,500) would be taxable upon conversion.

Will this opportunity always be available?

Roth IRAs, as is all tax policy, is subject to change and the availability of Backdoor Roth IRAs is not guaranteed. Roth IRAs were introduced as a way for people to save for retirement, but still be able to access the money without penalties. At first, if you wanted to convert an existing IRA into a Roth, you had to be beneath the income limits. The conversion cap has since been removed, as older and higher-income investors asked for the benefit of tax-free withdrawals in retirement. Despite a proposal in President Obama’s 2016 budget to prevent Roth conversions of after-tax dollars in an IRA—which would have mostly eliminated the so-called Backdoor Roth IRA—the strategy survived for at least one more year. The Backdoor Roth remains a subject of debate and since we are not sure where the new administration’s thinking is at on the topic, (Tax reform is a high priority, but no specific mention of Roth), you may want to take advantage of this strategy and you may want to do so before tax law changes are enacted.

Jack J. Cintorino, JD
Vice President/Senior Financial Planner

Prior to joining Janney, Jack was employed at AXA since October 2012 as Director/ Lead Manager-Senior Case Design Consultant, Estate and Charitable Planning. While at AXA, he moved onto a Regional Vice President role serving the Mid-Atlantic territory. He holds a BA degree from State University of New York at Stony Brook and a Juris Doctor (JD) degree from Touro College School of Law. 

Janney Montgomery Scott LLC, its affiliates, and its employees are not in the business of providing tax, regulatory, accounting, or legal advice. These materials and any tax-related statements are not intended or written to be used, and cannot be used or relied upon, by any taxpayer for the purpose of avoiding tax penalties. Any such taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor.

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