As covered in our 401(k) – Super Roth article, a Roth IRA offers an attractive tax benefit. But, what do you do if you do not have a 401(k) or your 401(k) does not allow post-tax contributions? The answer is the Backdoor Roth which is the conversion from a Traditional to a Roth IRA.
Both the Super Roth and Back Door options are for people who exceed the income limits (single filers that make over $139,000 or married, joint filers, that make over $206,000) for direct Roth IRA participation.
3 Steps for creating a Backdoor Roth:
- Make a non-deductible contribution to a Traditional IRA up to the yearly allowed amount (For example, the 2020 contribution limit was $6,000 and $7,000 if over age 50).
- Convert Traditional IRA to Roth IRA.
- All distributions that occur beyond the five-year waiting period (contributions plus growth) are tax-free.
Although the creating a Backdoor Roth steps are simple, there are a few hurdles to overcome.
Aggregation Rule – The IRS requires conversions from traditional IRAs to Roth IRAs to be done on a pro-rata tax basis. In other words, if 50% of your total traditional IRA balances are considered pre-tax and 50% are considered post-tax, then you would owe tax on 50% of the conversion plus any gains. So, if you have existing rollover IRAs from former employer plans, or have deducted any contributions in the past, you may be subject to this unattractive aggregation rule.
Proper Transfers – Conversions must be classified in one of three ways to avoid unwanted penalties:
- Rollover Transaction. You receive the funds and then deposit into Roth within 60 days.
- Trustee-to-Trustee Transfer. Funds are sent directly from your IRA provider to your Roth IRA provider.
- Same Trustee Transfer. This is the most common solution and involves simply internally journaling funds from an IRA account to a Roth IRA account at the same institution.
5-Year Waiting Period – Any funds converted to Roth IRA need to be parked for at least 5 years or the attainment of at least age 59½, whichever is longer, to receive the favorable tax-free treatment on gains. If you may need access to the funds during this time then this isn’t the best option for you.
If structured properly, the Backdoor Roth IRA can be an extremely beneficial strategy. If these hurdles can be overcome, there is an open back door for tax savings regardless of income. If you have questions or would like to discuss your specific situation in more detail, please do not hesitate to contact us using the form below.