Roth IRAs have some distinct perks for the long-term investor. Among them is the ability to take out tax-free withdrawals in retirement while never having to worry about required minimum distributions (RMDs). Still, if you’re relatively affluent, you may look at the income limits on this version of the individual retirement account (IRA) and decide that you have to steer clear.
There is another road to take if you want access to the benefits of a Roth, but don’t meet the requirements. Instead of investing directly in a Roth, you can roll over your nondeductible Traditional IRA contributions—for which there’s no income limit—into a “backdoor” Roth. From there the money will grow tax free, and you won’t have to pay the IRS a dime on qualified withdrawals once you reach the age of 59½. By dodging RMDs that would otherwise begin at age 70½, you’ll also enjoy added financial flexibility in your later years.
There are some serious tax consequences, however. Read carefully through the next paragraphs to learn what the process entails.
Who Can Benefit?
As of 2017 you’re only allowed to make Roth IRA contributions if you’re a single filer earning less than $133,000 a year or a joint filer who makes less than $196,000 (the numbers for 2018 are $135,000 and $199,000). However, those income limits don’t apply to Traditional IRAs—and they don’t apply to Roth rollovers either. This allows you to make nondeductible contributions to a Traditional IRA and subsequently roll them into a Roth. As you’ve already paid taxes on your contributions, you won’t pay any additional taxes when you do the conversion.
Once your funds are in a Roth, you can take advantage of its unique benefits, such as tax-deferred growth and tax-free qualified withdrawals. Under current IRS rules individuals under the age of 50 can contribute as much as $5,500 a year toward a Traditional (or Roth) IRA, and those age 50 or older can take advantage of a “catch up” provision that allows them to kick in an additional $1,000 annually.
If you’re married, that means both spouses can open up an IRA and, if you max out your contributions, roll up to $11,000 ($13,000, if you’re 50 or older) into a Roth each tax year. What’s great is that you can make after-tax contributions to a Traditional IRA even if you’ve put the maximum amount into your 401(k) at work. By using both accounts simultaneously, you’re only increasing the tax savings.
‘Pro Rata’ Rule
Where things can get a little more complicated is if you want to do a rollover and you already have multiple IRAs with both nondeductible and deductible contributions. Chalk it up to a vexing federal provision known as the IRA Aggregation Rule.
In the eyes of the IRS you can’t just take your nondeductible IRA funds and convert them into a Roth; it treats all your individual retirement accounts—including SIMPLE and SEP IRAs—as a single account. To determine how much of the distribution came from deductible versus nondeductible sources, you have to apply the “pro rata” rule.
Say you’re rolling IRA funds worth $50,000 into a Roth account, but only 20 percent of that is from nondeductible contributions. That means that only 20 percent of the rollover, or $10,000, is completely tax free. The remaining 80 percent of the distribution, or $40,000, will be subject to income taxes. Needless to say, the tax implications can be significant for larger transactions, so it’s worth crunching the numbers before proceeding with this strategy, preferably working with a financial advisor who can guide you through the process.
Keep in mind that even though you won’t face additional income taxes on the nondeductible contributions you roll into a Roth, you will have to pay tax on any gains you’ve accumulated. This means that the more time you allow your balance to grow before doing the conversion, the greater the tax liability you may face.
Averting Rollover Taxes
If your 401(k) accepts IRA rollovers, you may be able to sidestep a tax bill even if you’ve generated earnings from your investment. You simply move your pretax contributions—and any pretax gains—into the 401(k). These workplace plans don’t accept post-tax money, however, so the nondeductible contributions will have to stay in your IRA. Then you take that remaining post-tax IRA balance and proceed with a completely tax-free Roth rollover.
Let’s look at an example. Suppose you made $40,000 in nondeductible IRA contributions over the years, which have generated $20,000 in earnings. The $20,000 hasn’t been taxed yet, so you can roll that into the 401(k). The $40,000, on the other hand, is already post-tax money, so you can convert that to a Roth without any immediate tax implications.
Timing Is Imperative
If you’re going to proceed with the backdoor Roth strategy, realize that your timing can be vital. Under something called the “step transaction doctrine,” you can’t make multiple transactions that in concert with each other would constitute a violation of the tax code.
In this case you don’t want Uncle Sam to see your nondeductible Traditional IRA contributions and subsequent Roth conversion as a single, integrated step. If so, the IRS could slap a 6 percent excess contribution penalty on whatever you’ve put into the Roth. The key, then, is making sure that the transactions are indeed separate steps—and that means biding your time.
How long should you wait before completing a rollover? Expert opinions vary, but most recommend waiting at least one full statement cycle after you’ve made your nondeductible contribution to a Traditional IRA.