As we near the end of the year, I thought it would be a good idea to review the benefits of a backdoor Roth IRA.
Many people have incomes too high to allow them to contribute to a traditional IRA with pre-tax money. Though income limits are higher for Roth IRA contributions, there is still a limit. The backdoor Roth IRA is a way to get around the income limits imposed by the IRS.
Don't worry. The strategy is legit.
You have to make sure you follow the rules, especially when it comes time to take a distribution. When you own traditional IRAs funded with pre and after-tax dollars and Roth IRAs funded by converting traditional IRAs, you will be subject to the pro-rata rules on distribution.
Like most IRS rules, the devil is in the details. Mistakes can be costly, both in paying higher taxes and potential tax penalties for underpayment. We'll talk about the backdoor Roth IRA and the pro-rata rule to be sure you have the knowledge you need to make good decisions at distribution time.
With that brief introduction, let's get started.
Caution: The information in this post is for informational purposes only. It is not meant to be tax, legal, or investment advice. Before taking any action, you should seek competent, professional tax and legal counsel.
Is the Backdoor Roth IRA Right for You?
Roth IRA basics
Contributions and withdrawals
Roth IRAs allow investors to contribute after-tax dollars into an IRA whose earnings like traditional IRAs grow tax-free while in the account.
In 2018, you can contribute up to $5,500 into a Roth (or traditional) IRA. For those age 50 and above, an additional $1,000 can be added bringing the total to $6,500. In 2019, those limits increase by $500.00 to $6,000 for those under age 50 and $7,000 for those age 50 and above.
Another difference (and a major benefit) is that contributions to Roth IRAs can be withdrawn at any time without tax or penalty.
If held for five years, Roth IRA withdrawals are tax-free. If you are under age 59 1/2 and withdraw from the Roth, you will pay a ten percent penalty on earnings withdrawn. You pay no tax or penalty if you hold for five years and withdraw after reaching age 59 1/2.
Unlike traditional IRAs, Roth IRAs do not have required minimum distributions. You decide when and how you want to withdraw money. That, to me, is another significant benefit.
For many people, the income limits prevent them from making Roth IRA contributions. Here are the 2018 and 2019 income limits.
Source: IRS Roth Comparison Chart
Traditional IRA deductibility
Below are charts comparing 2018 and 2019 limits.
Source: IRS Deduction Limits
If you make an income above the limits listed and contribute to an employer retirement plan, you are ineligible to make a traditional IRA contribution with pre-tax dollars. What do we do if we want to contribute to a Roth IRA for the tax-free income benefits but make too much money?
Enter the backdoor Roth
The backdoor Roth IRA is simple on the surface. The first step is to make a non-deductible contribution to an IRA. As we discussed earlier, income limits do not apply for non-deductible IRAs. Stick to the contribution limits, and you're good to go.
For easier accounting, I recommend keeping your non-deductible IRA separate from IRAs in which you made pre-tax contributions.
Once the IRA is in place, the second step is to convert the traditional IRA to a Roth IRA. Here is where the potential pitfalls come into place. You might think that since you've already paid taxes on the non-deductible IRA contributions, you won't pay taxes when you convert.
Not so fast.
If you have traditional IRAs funded with pre-tax dollars, Roth IRAs funded by converting traditional IRAs, and other non-deductible IRAs, any withdrawals will be subject to the pro-rata rule. That means you will pay taxes on the converted money.
Here is an example:
Katy has an IRA worth $95.000. The entire IRA consists of pre-tax contributions and earnings. She wants to contribute to a Roth IRA but makes over $200,000, putting her over the income limit. Katy is also covered under an employer retirement plan. She is over the income limit for a deductible IRA contribution as well.
Katy decides she wants to make a non-deductible contribution to an IRA. Katy decides to contribute $5,000 in 2018. She knows about the backdoor Roth and decides to convert the $5,000 to a Roth. Within a week, she completes the conversion to the Roth, minimizing or eliminating taxes on any earnings (she left it in cash). She thinks because the money converted was after tax, she won't owe taxes on the converted money.
The pro-rata calculation formula
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Roth IRA and inherited IRA balances do not count in the calculation. Non-IRA employer plan balances get excluded as well. Here's how to calculate the pro-rata rule:
Total after-tax amounts in all applicable IRAs (those listed above) / Total balance of all applicable IRAs = % of distribution that is tax-free.
Because Katy has $95,000 in a traditional IRA consisting of pre-tax money, she will be subject to the pro-rata rule. Instead of the $5,000 conversion being tax-free, only 5.00% or $250.00 is tax-free. The remaining $$4,750 gets taxed at her ordinary income tax rate.
Here is the calculation – $5,000/100,000=5.00% or $250.00(5.00% X $5,000). Katy is married. Their combined income falls into the 24% tax-bracket, making the tax due on the conversion $1,140.00 ($4,750 x 24%). I'm sure Katy would not be happy getting the extra tax bill.
Watch out for this rollover trap
The IRA balance that matters when calculating the pro-rata rate is the year-end balance. If you converted an IRA in February and rolled over a company retirement plan to an IRA later in the year, that balance is added to the total IRA balance for the year. Because of that, it could mean a larger percentage of the conversion amount or the non-taxable IRA balance gets taxed.
Let's look at an example. Katy's sister, Lisa, has an IRA balance of $100,000. That balance consists of $75,000 of pre-tax (deductible) contributions and $25,000 of after-tax (non-deductible) contributions. Lisa also has a 401 (k) that's worth $400,000, all of which is pre-tax money. She converts the entire $100,000 IRA to a Roth. She will owe tax on $75,000 ($25,000/$75,000=25% tax-free, 75% taxable). Remember, plan assets still in the company do not get included in the calculation.
In the early summer, Lisa changes jobs. She decides to roll the $400,000 401(k) balance into an IRA. Since the $400,000 is now in an IRA and out of the company plan, she must include in the pro-rata calculation. The total in the IRA is now $500,000 instead of $100,000. The resulting taxable income increase from $75,000 to $95,000. Here's the calculation:
$25,000 (after tax amount) / $500,000 year-end balance ($100,000 + $400,000) = 5%. 5% x 100,000 = $5,000. That's now the tax-free amount vs. $25,000 before the rollover. The taxable income is now $95,000 (100,000 – 5,000). Using the same 24% bracket as before, the tax goes from $18,000 to $22,800, adding an additional $4,800 to her tax bill.
Waiting until January of the following year to make the rollover eliminates the extra tax. Another option would be to roll the $400,000 401 (k) from the old company's plan to the new company's plan (assuming the plan allows it). Keeping the money in an employer plan means it won't get included in the year-end balance.
Exceptions to the pro-rata rule
Qualified charitable distributions
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An ancillary benefit of this is to reduce the pre-tax amounts in the whole IRA bucket to calculate the pro-rata percentage. This only works if the taxpayer has both pre and post-tax money in IRAs.
Qualified HSA distributions
The IRS allows taxpayers to transfer money from their IRAs to fund their Health Savings Accounts. This is known as the qualified HSA funding distribution or QHFD. The transfer is limited to a one-time transfer in a given year up to the maximum contribution limit for the HSA (less any contribution already made for the year). you can only pre-tax funds for the QHFD.
Rollover to employer-sponsored retirement plans
The most common rollover transaction is moving company-sponsored retirement plans to IRAs. There are advantages to going the other direction; that is rolling IRA money into an employer retirement plan. If you have large IRAs with pre-tax money in addition to after-tax or converted Roth IRA accounts, the best option may be to roll the pre-tax IRA money into your employer retirement plan. Check with the employer plan to see if they accept rollovers from IRAs. Employer plans can only accept pre-tax money. This will reduce the amount of IRA money counted for the pro-rata rule and may help reduce the taxable income.
Millennials who have been working for several years do their best to max out their 401 (k) plans as they strive for financial independence. They may find themselves with high balances in those accounts. Many of them have or will roll those plans into individual IRAs. Many will take advantage of the backdoor Roth to get their retirement money into tax-favored vehicles.
In most cases, Boomers, started making contributions to traditional IRAs before Roth IRAs existed. When their income increased throughout their careers, those pre-tax contributions had to stop. That meant the best way to fund retirement was contributing larger amounts of money to their employer-sponsored plans. As they changed jobs, many rolled their old employer-sponsored plans into individual IRAs. For many Boomers, most of the IRA money is pre-tax traditional IRA accounts.
Regardless of which group you belong to, it's essential to understand the pro-rata rules to get the most out of any distributions. For Millennials and Gen Xers, it may not seem necessary. Think about it this way. You contribute to these accounts to build up money to help you retire. In many cases, that means early retirement.
Learn the tax and distributions rules now while you're still building your nest egg. Distribution planning should be a part of the decision on which accounts you contribute based on both current tax-law and future distributions.