If you consume any personal finance content on social media, blogs, or podcasts, you’ve probably heard the phrase “Backdoor Roth IRA”.
What is a backdoor Roth IRA? Who qualifies for a backdoor Roth IRA? And is a backdoor Roth IRA right for you?
Let’s find out.
What is a backdoor Roth IRA?
A backdoor Roth IRA isn’t a type of account. Instead, it is a series of transactions that allow an individual who normally wouldn’t qualify to make a direct contribution to a Roth IRA to fund a Roth IRA through a conversion.
Should I do a Roth IRA Conversion?
The steps for a backdoor Roth IRA are simple.
1. Open a Traditional IRA if you don’t already have one.
2. Make a non-deductible cash contribution to your Traditional IRA.
3. Within a business day or two, convert the dollars contributed to your Traditional IRA to a Roth IRA.
When completed correctly, this is a non-taxable transaction. If desired, you can do this on an annual basis to build up your Roth IRA balances.
Who qualifies for a backdoor Roth IRA?
Anyone who can contribute to a Traditional IRA can use the backdoor to access a Roth IRA. But just because you can, doesn’t mean you should.
Is a backdoor Roth IRA right for me?
Maybe. There are some things you need to keep in mind before committing to funding a Roth IRA from the backdoor.
Tax Deduction Today or Tax-Free Withdrawals Tomorrow
To successfully complete a backdoor Roth IRA transaction, your Traditional IRA contribution needs to be non-deductible. If you are otherwise eligible to deduct your Traditional IRA contribution, weigh carefully if access to a Roth IRA is worth giving up a tax deduction.
How Do Taxes Work?
Penalties on Early Withdrawals
Once you fund a retirement account like an IRA, it is difficult to gain access to the money in that account without triggering a 10% early withdrawal penalty.
The Five-Year Rule
If your Roth IRA is brand new, and you are otherwise eligible to make a normal distribution, the earnings on converted amounts are taxable if withdrawn within five years of establishing the Roth IRA.
The Pro Rata and IRA Aggregation Rules
When completed correctly, a backdoor Roth IRA is a non-taxable transaction. You may also know that Roth IRAs are always funded with after tax dollars. This is where the Pro Rata and IRA Aggregation Rules rule may come into play.
The Pro Rata Rule states that you must pay tax on a prorated portion of any Roth IRA conversions to account for any existing pre-tax balances. In other words, you can’t pick and choose which dollars you are converting.
The IRA Aggregation rule states that if you convert to a Roth IRA, all your Traditional, Rollover, SEP, and SIMPLE IRA balances will be included in the computation to determine how much of your Roth IRA conversion is taxable.
Let’s look at some examples.
Tax-Free Conversion
Say you do not have any existing IRAs, and you follow the steps outlined above where you make a non-deductible contribution a Traditional IRA. Because your Traditional IRA contribution was not tax deductible, you did not have any earnings on the contribution when you converted, and you did not have any other non-Roth IRA balances, you converted nothing but post-tax dollars. So, no part of the conversion is taxable.
Taxable Conversion
Now let’s assume you have a Traditional IRA with a pre-tax balance of $50,000. You open a second Traditional IRA and make a non-deductible contribution of $7,500 and then convert that balance.
The Pro Rata rule means that you must pro-rate your pre-tax and post-tax dollars across your conversion. The IRA Aggregation Rule says that you must include your $50,000 Traditional IRA in the computations to determine how much of the converted amount is taxable
Under these circumstances, 87% of the $7,500 you converted is taxable.[1]You’ll have taxes due on $6,521 of the conversion. Depending on your marginal tax bracket[2], the conversion could cost you as much as $2,412 in taxes.
Because of the IRA Aggregation and Pro Rata Rules, people with large Traditional, Rollover, SEP, or SIMPLE IRA balances are not good candidates for a backdoor Roth. (The IRA Aggregation rule does not apply to 401(k) balances.)
Putting it All Together
A backdoor Roth IRA can be a powerful wealth building tool. While setting yourself up to benefit can take some effort, over long periods of time, your work can pay off in the form of Roth IRA balances that will avoid Required Minimum Distributions and income taxes for the duration of your life.
Plan for Wealth
Roth IRAs are also a powerful wealth transfer tool. Because they are exempt from Required Minium Distributions, you can allow them to compound for the rest of your life. When your Roth IRA transfers to your heirs, they will not have to pay taxes on distributions they take from the account.
Want to use a backdoor Roth IRA in your wealth building journey?
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The information offered is provided to you for informational purposes only. Baird is not a legal or tax services provider and you are strongly encouraged to seek the advice of the appropriate professional advisors before taking any action.