Backdoor Roth IRAs

/ February 20, 2013

Although you may earn too much to contribute to a Roth IRA, there is no income restriction to convert a traditional IRA to a Roth IRA.

What is a Backdoor Roth IRA?

Open Sign - iStockThe Backdoor Roth IRA is an indirect way to contribute to a Roth IRA when your income is too high to contribute directly into a Roth IRA. Instead, contribute after-tax dollars into a traditional IRA and then convert the contributions later into a Roth IRA. Converting traditional IRAs into Roth IRAs became possible in 2010 because Congress eliminated income limits for Roth IRA conversions. By doing so, many people can now contribute to a Roth directly or indirectly.

Who Should Consider A Backdoor Roth IRA?

If your income is “too high” to contribute to a Roth IRA, a Backdoor Roth might make sense. For 2012, the income limits to contribute to a Roth were $183,000 for those married and filing jointly, and $125,000 for single taxpayers. You have until April 15th 2013 to make contributions for tax year 2012 – $5,000 per person or $6,000 if you were age 50 or older by the end of 2012.

If your income is lower than these thresholds, you can either contribute after-tax dollars directly into a Roth IRA or contribute pre-tax dollars into a traditional IRA.

Important Considerations

When converting traditional IRAs into Roth IRAs, although there is not the normal 10% penalty for withdrawals, the money converted is treated as ordinary income and taxed accordingly. If your after-tax contributions represent your only IRA money, your conversion to a Roth IRA is tax-free. It gets trickier if you already have IRA accounts (whether in the same account or spread over multiple accounts) that were funded with pre-tax dollars because you cannot just convert the after-tax portion. Instead, you must convert your IRA assets “pro-rata.”   The tax-free portion of the conversion is based on the ratio of after-tax contributions to the total balance in all of your traditional IRAs. For example, if your total IRA balance is $100,000 and only 5% came from after-tax contributions, then only 5% of any conversion would be tax-free. The rest would be taxed at your regular income tax rate.

The Benefits

The benefits of Roth IRAs might overcome the hurdle of having to pay taxes immediately when doing a Roth conversion. Once the money is in the Roth IRA, the gains build up tax-free and you will be able to withdraw the money tax-free in retirement and not be subject to the required minimum distributions at age 701/2. In addition, if you do not need the money from your Roth IRA, the money will pass to your heirs income tax free. Another potential benefit is that the tax rate you pay now might be lower than tax rates in the future, as it is quite likely that income tax rates will increase.

Managing Taxes

If you currently have other IRA assets, a Back Door Roth IRA will  have tax implications, although there are ways to manage them.

Converting only a portion of your IRA assets each year might make sense as part of a systematic program of diversifying your retirement assets so that you have both before-tax and after-tax assets. You then have the freedom and flexibility of deciding when to take withdrawals and controlling taxes in retirement. One can do this without taking a huge tax bite in any given year by converting only a portion each year. One would only convert an amount that would increase your income to the top-end of your current bracket and make conversions over multiple years.

There is one possible way to work around the tax issue. If your current employer has a retirement plan, you may be able to roll the pre-tax assets from your IRA into it, if the plan’s rules allow. In doing so, only the after-tax contributions would be left in your IRA and subject to the pro-rata rule. Assets in a 401(k) or similar retirement plans are not included in pro-rata calculations. While attractive from a tax standpoint, there are other considerations in rolling IRA assets back into a company 401(k) such as fees, performance and access to a narrower range of investment choices.

Making the Conversion

How long should you wait to convert? It is a gray area and many differ in their opinions. Some advocate converting immediately to limit the tax bite on the conversion, while others suggest a holding period of up to six months. Waiting some period, say one to two months seems prudent as the government did away with income restrictions on Roth conversions, not Roth contributions.  An immediate Roth conversion, while technically allowed, gives the appearance of a direct contribution.

Conclusion

A Back Door Roth IRA might be a good option for many high-income professionals who want to save more for their retirement and are already maxing out contributions in their other retirement plans or want to have some tax diversification in their retirement assets. There are many important considerations and looking at your complete financial picture will be necessary in making a decision that is right for you. Working with a trusted tax professional and investment advisor might help you make a better-informed decision and put in place a plan that makes sense for you.

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