Backdoor Roth IRAs

A Potential Way for High Income Earners to Participate in Roth IRAs

One of the primary benefits of a Roth IRA is that any money contributed grows tax-free and can be withdrawn without any further income taxation. In addition, unlike a traditional IRA, Roth IRAs have no required lifetime minimum distributions. Roth IRAs can also be passed on to heirs income tax-free . This allows investments to grow and compound tax-free  over many years.

However, the traditional contribution ("front door") for Roth IRAs is currently not available for higher income earners. Married couples earning $194,000 or more and singles earning $132,000 or more in 2016 are still barred from contributing directly to Roth IRAs.

In 2010, Congress changed the rules and since then anyone can convert a traditional IRA to a Roth IRA. However, higher income earners are still ineligible to contribute to a Roth IRA.

A Backdoor Roth IRA is a strategy for some higher income earners to participate in Roth IRAs. It is accomplished by first putting money into a traditional nondeductible IRA and then rolling the contribution into a Roth IRA. While this strategy is reasonably straightforward, there are several rules to be aware of in order to not incur unintended tax consequences. Working with a knowledgeable financial or tax professional can provide some great guidance and value.

How Does a Backdoor Roth IRA Conversion Work?

The Backdoor Roth conversion consists of two simple steps:

  1. Make a nondeductible contribution to your traditional IRA.
  2. Consult with your financial advisor and tax professional and then convert the traditional IRA into a Roth IRA (potentially paying little to no taxes on the conversion).

There's one big caveat: This strategy works best tax-wise for people who don't already have money in traditional IRAs. That's because in conversions, earnings and previously untaxed contributions in traditional IRAs are taxed—and that tax is figured based on all your traditional IRAs, even ones not being converted.

For an investor who doesn't already hold any traditional IRAs, creating one and then quickly converting it into a Roth IRA will incur little or no tax, because after a short holding period there's likely to be little or no appreciation or interest earned in the account. However, if a traditional deductible IRAs is already being funded or held, a far higher tax bill could be incurred on the conversion of a new IRA.

The maximum contribution to a non-deductible IRA for 2016 is $5,500, or $6,500 for those age 50 or older. The deadline for making a contribution for the 2016 tax year is April 15, 2017. This non-deductible IRA can then be used in a backdoor Roth IRA conversion. It is important to review all of related retirement accounts before converting to a Roth IRA. Rules for Roth conversions can be complicated so it is advised to speak with your financial advisor and tax professional prior to undertaking it.