Making IRA contributions is more complicated than it used to be; there are traditional, non-deductible and Roth IRAs, and each has different income thresholds for eligibility along with rules about whether you or your spouse have retirement plans at work. However, if you don’t qualify to make a contribution directly, with a couple of extra steps, you can make what is called a “Back Door” Roth IRA contribution, which gets your money into the Roth’s enviable tax-free growth environment.
Why would you want to make a Roth IRA contribution?
Even though you don’t get a tax deduction for making a Roth IRA contribution, the Roth environment is attractive because all of the growth is tax-free. Over time, we hope that the missed tax-deduction on the contribution is a small compared to the tax advantage of not paying taxes on the growth. In a Roth IRA, all withdrawals are tax free.* In a traditional IRA, whether or not you get a tax deduction in the year you make the contribution, all growth is taxed as ordinary income.**
The strategy has been around for a while, it was legitimized with recent tax reform. The benefits of Roth investing are 1) tax-free growth and withdrawals and 2) Roth accounts aren’t required to take distributions after age 73 and provide more flexibility and tax diversification of retirement income.
Instructions for making a Back Door Roth contribution:
Step 1: Check your income. If your Modified Adjusted Gross Income is under 218,000 (around $138,000 for single filers) you can make a full Roth IRA contribution. The amount you can contribute declines until your income is over $228,000 (153,000 single). At that point you are not eligible to make a Roth IRA contribution DIRECTLY.
If you can't make a direct Roth contribution, you may still be able to get money into the Roth envioronment.
Step 2: Talk to us or your advisor first if you have other traditional, SEP or SIMPLE IRAs, you may need to roll them into a 401k for the strategy to work.
Step 3: If you have determined that the Back Door Roth will work for you, make a non-deductible IRA contribution and let your CPA know to track of it on a form 8606***
Step 4: Convert the non-deductible IRA to a Roth IRA. From that point forward, growth will be tax free.
If you like the idea of Roth contributions, check to see if your 401k allows Roth contributions, they aren't limited by the amount of income you make. (See this article on Mega Back Door Roth Contributions for 401k investors)
There are a few hoops to jump through, but this “back door” contribution into a non-deductible IRA then converting it to a Roth is a useful work-around for avoiding the income-based restrictions on Roth IRAs. We can help you decide whether this strategy fits into your financial plan and can help you with the process.
*Be careful of the 5-year rule – you must have had a Roth IRA for at least 5 tax years before you can withdraw the earnings tax free. Otherwise withdrawn earnings are taxed (and penalized if you are younger than 59.5). The original principal you contributed is always available tax and penalty-free.
**If you take withdrawals from a traditional IRA before age 59.5, you will be taxed and penalized unless a specific exemption applies.
***Any after-tax contributions are tracked on an IRS Form 8606 so you don’t pay taxes twice.