In this blog post, we would like to focus on a lesser-known retirement savings strategy, the “backdoor Roth IRA.”
A backdoor Roth IRA is a great way for high income earners, particularly ones with minimal IRA assets (see aggregation rule below), to save for retirement.
As you may recall, there are a number of differences between traditional IRAs and Roth IRAs, but the biggest is contributions to Roth IRAs are made with after-tax dollars, grow tax-free and can be pulled out in retirement tax-free, provided all withdrawal requirements are met. Conversely, contributions to traditional IRAs are made with pre-tax dollars (i.e. tax deductible) and are taxed when pulled out in retirement. The analysis of whether contributing to one over the other is based on a number of factors, but the most significant is whether one expects to be paying higher or lower taxes in the future (via a change in tax rates and/or tax bracket). If higher in the future, it makes sense to pay taxes now at a lower rate and do a Roth IRA contribution, and vice versa.
There are a couple unique benefits to Roth IRAs over traditional IRAs. One, there are no required minimum distributions (RMDs) for Roth IRAs when the account owner turns 70½ like there are for traditional IRAs. Two, people who participate in work retirement plans (i.e. 401k, 403b, etc.) can also make Roth IRA contributions.
If Roth IRAs are so great, why doesn’t everyone contribute to one? Unfortunately, there are income limits on being able to make Roth IRA contributions. For 2019, individuals who make over $122,000 and couples who make over $193,000 can’t make full Roth IRA contributions. However, for people over the income limit who still want to make Roth IRA contributions, all is not lost. Enter the backdoor Roth IRA.
The way to get money into a Roth IRA, if over the income limit, is to make a non-deductible IRA contribution and then, since there are no income limits for Roth IRA conversions, convert the contribution to a Roth IRA. There is no income limit for making a non-deductible IRA contribution and, because it’s not deductible, can be converted to a Roth IRA tax-free. This is a great way to participate in a Roth IRA for those that would otherwise be disqualified due to the income limit.
This strategy works best if an individual does not have existing IRA assets made up of pre-tax contributions. The reason is because the IRS requires one to aggregate all IRA accounts when looking at how much of a conversion is taxable. For example, let’s say Betty has a $100,000 IRA rollover and wants to make a $6,000 Roth IRA contribution via a backdoor Roth conversion. She would have to aggregate her $100,000 IRA with the $6,000 non-deductible IRA contribution, and if she converted $6,000 to a Roth IRA, 94.3% ($100,000 pre-tax / ($106,000 pre-tax + after-tax) of it would be treated as a taxable IRA distribution (similar to a normal Roth conversion). The good news is spouses’ IRAs, inherited IRAs and work retirement plans (401(k)s, 403(b)s, etc.) do not count in this aggregation rule.
If all criteria are met, being able to stash up to $14,000/yr for a couple in tax-free investment vehicles, would be a great resource to have in retirement.
As a reminder, the deadline for 2019 retirement account contributions (including Roth IRAs and traditional IRAs) is April 15th, 2020. Individuals who are under the age of 50 can contribute $6,000 and over 50 can contribute $7,000 to either type of IRA.
If you have any questions or would like to discuss which retirement savings strategy is best for you, please don’t hesitate to reach out.
Mike Gallagher, Director of Investments