What is a Backdoor Roth IRA?

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If you are above the income limits for a Roth IRA don’t assume that you are restricted from opening one. The Backdoor Roth IRA is a tax loophole that allows anyone to open a Roth IRA. For 2020 if you are a Single filer and earn over $139k (over $206k for married filing jointly) you cannot contribute to a Roth IRA. But here a way to do it.

What is a Backdoor Roth IRA?

The Backdoor Roth IRA is made possible by a tax loophole that gives high income earners the ability take advantage of the tax-advantages offered by the Roth IRA.

To understand how it works, first let’s take a quick look at traditional and Roth IRA rules.

Traditional IRA

The traditional IRA was established in 1974 and allows an investor to save retirement funds on a tax-free basis through a tax deduction on annual contributions. Contributions are made on a pre-tax basis and all earnings in an IRA account aren’t taxed until the funds are distributed. The tax deduction on the contributions however is only available to those who don’t have a 401(k) or some other retirement plan at work or whose income is below certain limits.

Single tax filers who earn below $75,000 and married joint filers who earn below $206,000 (for 2020) can benefit from some level of a tax deduction from a traditional IRA.

What’s important to know (for those considering the Backdoor Roth IRA) is that the tax law changed in 2010 so that now anyone can contribute to a traditional IRA, no matter your income level. You can’t however deduct the contribution if your income level is above the IRS limits.

Roth IRA

The Roth IRA does not come with a tax deduction but offers a benefit many investors find to be even more valuable – tax-free earnings. Contributions to a Roth IRA are not tax deductible, in other words one would contribute after tax income in to a Roth IRA. Distributions including any gains from investments from a Roth IRA however are tax-free in to perpetuity.

The Roth IRA is a popular option for those who expect taxes will rise in the future.

The Roth IRA however has some restrictions on contributions. Unlike the traditional IRA, you cannot contribute to a Roth IRA at all if your income is above certain limits. IRS limits for 2020 are below $206,000 for joint filers and $139,000 for single filers.

Backdoor Roth IRA

So, for example if you’re a single-filer, who makes more than $139,000, you would be above the income limit when it comes to contributing to a Roth IRA.

But, in 2010 a change was made to the tax code to remove the income limit for making a contribution to a traditional IRA, establishing a non-deductible traditional IRA. This created a back door loophole for high income earners who cannot deduct the contribution amount from their tax bill.

Once the non-deductible traditional IRA is opened, an account owner can then can roll their traditional IRA balance into a Roth IRA. Basically, it’s a two-step process that allows high-income earners to access the benefits of the Roth IRA, despite the program’s income limits.

Backdoor Roth vs. Roth Conversion

In a straightforward Roth conversion, you can take any existing IRA balance and convert it into a Roth IRA. When you do this, you have to pay taxes on the amount you convert. You pay taxes on both the principal (the amount you contributed) and any earnings since the account was opened. For example if your existing IRA balance is $10,000 and you wish to convert it to a Roth IRA and you are in the 30% tax bracket. You would have to pay $3000 in taxes on the existing IRA balance and convert the remaining $7,000 into a Roth IRA.

With a Backdoor Roth IRA however, it’s possible to avoid this large tax hit because you’re not deducting the amount you contribute to the nondeductible traditional IRA.

The negative side to a Backdoor Roth

There are one potential downsides to consider if you’re thinking about funding a Roth IRA through the back door.

The pro-rata rule

When it comes to taxes, nothing is easy. And this is especially true when you take advantage of loopholes.

In a nutshell, the pro rata rule states that any withdrawals you take from IRAs be equally divided between taxable and non-taxable funds.

Under the pro-rata rule, ALL of your IRA holdings will effect the tax consequences of opening a Backdoor Roth.

For example:

  1. You have $45,000 in a rollover IRA.
  2. Then you contribute an additional $5,000 in a new nondeductible IRA.
  3. You now have a ratio of 9:1 of taxable to non-taxable money.
  4. When you convert the $5,000 nondeductible IRA to a Roth, you will actually owe taxes on $4,500 of the amount converted. That’s because 90 percent of your available IRA funds has never been taxed.

If you have a sizable existing IRA balance this could create a large tax burden for the conversion year.

The backdoor Roth IRA isn’t for everyone but for some high income earners, it can be a great way to get access to a tax-advantaged retirement strategy and boost your nest egg.

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