The Roth IRA (Roth for short) is a wonderful investment vehicle with many advantages. Funded with after-tax dollars, it grows tax-deferred until money comes out, which is usually tax-free. It’s great for all ages and since there are no required minimum distributions with a Roth, you can take as much or as little as you want or leave it all for heirs.
Unfortunately, there are contribution limits to the Roth. One can only contribute 100% of “earned income” up to $6,000 a year ($7,000 if you’re age 50 or older). Additionally, that amount of contribution decreases when one’s “modified adjusted gross income” (MAGI for short) hits a certain threshold. For a single tax filer, the limit is $139,000 in 2020 and $140,000 in 2021. For those filing a joint return, the threshold is $206,000 in 2020 and $208,000 in 2021.
But what if you want to maximize your Roth contribution each year and you exceed those amounts? That’s where the “backdoor Roth” offers a nice workaround.
What is a Backdoor Roth IRA?
The backdoor Roth IRA isn’t a special type of Roth. According to Investopedia, it is “an informal name for a complicated, IRS-sanctioned method for high-income taxpayers to fund a Roth, even if their income is higher than the maximum the IRS allows for regular Roth contributions.” This is not a way to dodge taxes but should provide future tax savings.
No matter what your MAGI is, dollars in a Traditional IRA can be converted to a Roth with income tax paid in the year those dollars are converted. But you wouldn’t want to go that route if you’re expected to be in a lower tax bracket in years to come when funds are needed. So for those with MAGIs in the six figures converting existing Traditional IRA dollars into a Roth thus triggering unwanted taxes isn’t prudent. Yet the desire to get as many dollars as possible into the Roth is warranted.
The best backdoor Roth approach is funding a non-deductible IRA to the max and immediately converting the dollars to a Roth. You fund this non-deductible IRA with after-tax dollars and make the conversion before any growth happens, literally within days. But there is a “pro-rata rule” you need to be aware of: the IRS looks at all Traditional IRAs and determines what percentage of the money converted to the Roth is taxable. You can’t just choose to only convert the after-tax dollars; the IRS applies the pro-rata rule to all of it and to your IRA balance at the end of the year, not at the time of conversion. Here’s an example of how to efficiently maneuver this strategy.
Example of a Backdoor Roth IRA
After tumbling down the hill many times, Jack and Jill now run a very successful water delivery business. They make too much money to contribute to a Roth and Jack has significant dollars in his IRA he rolled over from his old 401(k) plan. Fortunately, Jill converted all her few IRA dollars to her Roth years ago when they just started their business – “Fetchin’ Water” – and they were scraping by. Now only Jill yearly contributes the max to her non-deductible IRA and within a day, converts the dollars to her Roth and buys aggressive investments that should grow nicely for retirement. At times, Jill even takes money out of their joint brokerage account instead of cash flow to fund the contribution.
Withdrawing Money from a Backdoor Roth IRA
It’s important to note that the funds you pass through an IRA to a Roth are considered converted funds, not contributions. Thus, you must wait five years to have penalty-free access to them if you’re under the age of 59½. So out of the three types of funds in a Roth – contributions, converted, and growth – it’s only the contributions that can always be withdrawn tax and penalty-free.
But still, it is wonderful to have an account where there’s regular funding, assets grow and taxes are never paid. And putting the aggressive portion of your portfolio in a Roth, especially if you have five-plus years to invest, only makes sense. There are some special rules that can apply to this maneuver so check with your tax and/or financial advisor about those that apply to your situation. At Stewardship Advisors, we’re also happy to help you navigate the rules and implement this plan. Contact us to schedule an introductory meeting.