- It’s a method to side-step the income limits of a ROTH IRA
- It’s perfectly legal
- It’s ideal for those who don’t already have a Traditional IRA
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It’s a new year and perhaps you’re re-thinking your retirement strategy. For most people, a ROTH IRA is an excellent investment vehicle because it allows your savings (using after-tax dollars) to grow and be withdrawn FREE of income tax. That’s a wonderful thing. But a portion of you reading this may be ineligible for a ROTH contribution. In this article, I’ll highlight the key features of a “Backdoor” ROTH and whether it’s right for you.
What is a Backdoor ROTH?
While it may sound like a devious loophole, a Backdoor ROTH is an IRS-sanctioned method of side-stepping the income limits of a ROTH IRA. Surprising fact: It’s not new. It has existed since 2010. It’s designed for those with an adjusted gross income greater than $206,000, if married filing jointly, or $139,000, if single.
How it works
The Backdoor ROTH is a 2-step process. First, you make an after-tax contribution to a Traditional IRA up to $6,000 for those under 50, and up to $7,000 for those 50+. (This is reported to the IRS using Form 8606, “Nondeductible IRAs”.) Once the Traditional IRA has been funded, it is then converted to a ROTH IRA. This can happen in a matter of days; however, we recommend to our clients that they wait a minimum of one statement cycle (anywhere from 30 to 90 days).
Disadvantages of a Backdoor ROTH
Yes, like many things, there is a catch. The big one here is that the IRS taxes conversions from Traditional to ROTH IRAs using a “pro rata” formula. The pro rata calculation assesses the total value for all of your non-ROTH IRA accounts ─ including SEP and simple IRAs ─ to determine what is taxable when before and after-tax dollars are commingled.
Example: You have a total of $100,000 in Traditional IRA funds, which includes $10,000 in after-tax dollars. Any conversion or withdrawal would be 90% taxable and 10% tax-free. Therefore, the Backdoor ROTH is not ideal for those with traditional IRAs that have large pre-tax balances.
Another shortcoming? Contributions made via the Backdoor ROTH cannot be withdrawn from for a minimum of 5 years following a conversion.
After reviewing the pros and cons, the Backdoor ROTH IRA is ideal for those who currently do not have a Traditional IRA and still have some years before they plan to retire. For those that do have a Traditional IRA with pre-tax dollars, a ROTH conversion may be appropriate in certain circumstances. Be sure to speak with your financial and tax advisors before making these decisions.
About the Author
Alex Albert is a Certified Financial Planner for East Greenwich-based Lincoln Capital, a financial planning and wealth management firm. He is a graduate of the University of Rhode Island and earned CFP® certification from Bryant University.