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Is a Backdoor Roth IRA Right for You?

| By Matthew Snider

As we come to the end of tax filing season, the number of calls into my office have picked up considerably, mostly from people asking me whether or not a backdoor Roth IRA would be beneficial to them in their individual situations. So with that in mind, let’s go over what a backdoor Roth IRA is and what it does.  

Three Types of IRAs

It might be helpful to explain the three types of IRAs: Traditional, Non-deductible and Roth. There are others, but these are the most common. The differences lie in the tax treatment of each. All three have the same $6,000 contribution limit for 2021 and 2022 for those under 50 and an additional $1,000 catch-up for those ages 50 and older. 

The Traditional IRA is the most popular type of IRA and allows for an upfront tax break. By allowing these contributions to be deductible, your taxable income for the year is lower. Your earnings grow tax deferred and taxes are ultimately assessed on your withdrawals at a later point in time, usually in retirement.  

The Non-deductible IRA is exactly as it suggests: IRA contributions are not deductible because they are after-tax money. The reason for the inability to deduct the contribution on your taxes is based on access to an employer retirement plan and your income limits. Like the traditional IRA, the nondeductible IRA account offers tax-deferred growth. Taxes in retirement are due on any earnings growth that you withdraw—but not the principal, since the account was funded with after-tax dollars.  

The Roth IRA does not allow for deductible contributions. The real benefit of this account is the earnings grow tax deferred and withdrawals are tax-free. There is one catch to the Roth, however, and that is if your modified adjusted gross income is over a certain level your contribution can be phased out. 

For single income filers, the phase-out starts at $125,000, and anyone over $140,000 of modified adjustable gross income is not eligible. For those married filing jointly, the lower limit is $198,000 to the upper limit of $208,000. In 2022, those phase-outs are for single income filers, $129,000 to $144,000, and married filing jointly, $204,000 to $214,000.

A ‘Cream in the Coffee’ Rule for Better Tasting Results 

Income limitations can exclude high-income earners from contributing to a Roth or a traditional IRA since their contributions would not be deductible given their income. This is where the backdoor Roth comes into play. You would establish a nondeductible IRA and contribute to the account. Once the account is funded with an after-tax contribution, you would then convert the IRA to a Roth IRA. 

By utilizing this strategy, you may be able to do a conversion to a Roth IRA with little or no tax impact since the IRA that you are converting contains just after-tax dollars. Now, this assumes no interest or growth. This is what is referred to as a “Backdoor Roth IRA,” and it is considered a legal transaction.  

Obviously, this particular strategy works best if you do not currently own any other traditional, SEP, or SIMPLE IRAs, and the reason is due to what is known as the “cream in the coffee” rule, which states that distributions and conversions are a pro-rated amount of before-tax and after-tax dollars. Multiple IRAs are viewed in the aggregate, or, in other words, all of your IRAs are considered the same IRA. Therefore, you cannot isolate the after-tax monies and you can only convert that portion. 

To use the coffee analogy: once the cream (the after-tax money), is added to the coffee, (the pre-tax money), it all becomes intertwined. Every sip or distribution is a combination of cream and coffee, or with IRA’s pre- and after-tax money. It also answers the question as to why backdoor Roth IRAs are best used for those that do not have any other IRA accounts. The accounting in these cases can get complicated and cumbersome.  

If you’re going to implement this technique, another critical point is that you do not add any new IRAs between the time of the conversion and year-end. 

This is because the calculation that determines the before-tax and after-tax dollars in the conversion uses the balances of your IRAs at the end of the year. So, if you do this technique and later retire or change employers, and want to roll over your employer plan, you would be wise to wait until the following year.  

Any Investment Must Fit Your Situation

In addition, once the conversion is completed, you can’t go back and re-characterize it into a traditional IRA. And if you make a non-deductible IRA contrition, you will need to include Form 8606 when filing your taxes to keep track of your after-tax contributions.  

To summarize, the backdoor Roth may be an appropriate strategy for high-income earners. If that’s you, it must fit your situation. If not done correctly, it can easily become an accounting headache. Lastly, this is a strategy that has come under review from lawmakers in Washington, D.C., so there is no guarantee this technique will be around indefinitely.

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