Having accounts that are completely tax-free in retirement sounds too good to be true. I’m still amazed that Roth IRAs were created in the first place. However, income phaseouts mean that many high earners can’t directly contribute to a Roth IRA. But where there’s a will, there’s a way. Let’s take a look at how to make backdoor Roth IRA contributions.
Who Is Eligible?
If you’re eligible to make Roth IRA contributions in the first place, then none of this backdoor stuff is needed. For 2020, the income phaseouts for Roth IRA contributions are $196,000 for married filers and $124,000 for single filers.
If you’re making less than those limits, you don’t need to make backdoor Roth IRA contributions – you can just make direct contributions. However, once you’re in phaseout territory, your ability to contribute goes away quickly.
How Do You Make Backdoor Roth IRA Contributions?
Backdoor Roth IRA contributions are essentially a three-step process:
- Make a non-deductible contribution to your traditional IRA,
- Convert your IRA into a Roth IRA, and
- Properly fill out Form 8606 and include it with your taxes.
The reason this works is because you’re making a non-deductible IRA contribution. Since you’ve already paid taxes on that money, you will not need to pay taxes on the Roth IRA conversion. The key comes in telling the IRS that your contribution was non-deductible by including Form 8606 in your tax return.
How Much Can You Contribute?
Since Step 1 in this process is essentially an IRA contribution, the rules are the same. For 2020, you can contribute up to $6,000 (or up to $7,000 if you’re age 50 or older).
Another thing to note is that your spouse can also make these contributions, even if he or she has no earned income. The income limitations apply to your total household, so you can potentially save more in your Roth IRAs than you may have guessed.
Complications: The Pro-Rata Rule
For converting IRA assets to Roth IRA assets, one rule that could potentially complicate your backdoor Roth IRA contributions is the Pro-Rata Rule.
The Pro-Rata Rule says that anytime money comes out of an IRA, that money is taxed pro-rata based on how much of your total IRA hasn’t been taxed yet.
So, if all of your IRA contributions were deductible (you haven’t paid taxes on them yet), then 100% of a distribution/conversion is taxable. Conversely, if all of your IRA contributions were non-deductible (you paid taxes on them before they went in), then 0% of the distribution/conversion is taxable.
Uncle Sam wants his tax revenue! So, if you have not yet paid taxes on a portion of your IRA (these would be your normal, deductible contributions), then you’ll have to pay taxes on the pro-rata share of whatever hasn’t been taxed yet if you convert.
And just to make things more fun, the IRS looks at all of your IRAs as one, big ol’ IRA. So, if you have a SEP IRA, Simple IRA or traditional IRA, all of those assets must be taken into account.
What If You Have Existing IRA Assets?
Simply put, many of the tax advantages of the backdoor Roth IRA contribution strategy go away when you have to pay the taxes on the conversion.
If you do have other IRAs, you still have options. If the value of your IRAs is relatively small, you can go ahead and convert them if you don’t mind paying a little extra in taxes.
For IRAs, SEP IRAs or Simple IRAs with significant assets, you may be able to roll them into your current, active 401(k), 403(b) or other employer-sponsored retirement plan. Some employer plans are better than others, so keep that in mind before making any drastic moves. Let’s not let the tail wag the dog.
If you have any sort of business or side-hustle, you could also roll them into an Individual 401(k) plan. Once all your IRA buckets are free from tax-deferred assets, you now have the green light to start backdoor Roth IRA contributions.
Don’t Forget Form 8606
If the IRS taxes your conversion, all is for naught! Be sure and have a conversation with your CPA about including Form 8606 in your taxes for the year you make any backdoor Roth IRA contributions. Not only is it often forgotten, it’s important that the form be filled correctly.
What About The Step Doctrine?
For tax purposes, the Step Transaction Doctrine essentially says that any number of consecutive steps should be considered one whole transaction. So, does the IRS consider backdoor Roth IRA contributions verboten? Not necessarily.
This strategy has been around for years and there has been plenty of endorsement from tax professionals over time. At this point, there is very little risk in implementing this strategy as part of your annual financial planning.
Are Backdoor Roth IRA Contributions Right For You?
If you’re wondering if backdoor Roth IRA contributions are right for you, then click here to set up a quick, complimentary introduction call to see if Prana Wealth is a good fit. We do still have the capacity to take on new clients this year.
As a fee-only financial advisor in Atlanta, we can (and do) work virtually with clients all across the U.S. In the past, we’ve helped plenty of clients make backdoor Roth IRA contributions a part of their annual finances, where it was appropriate.
We’re here to help you when you’re ready.
