Opening Up the Door – The What, Why, and How to make a Back-Door Roth IRA Contribution:
Akiva Schreiber, Tax Director
May 6, 2022
The Basics: What is a Roth IRA?
Similar to a Traditional IRA, a Roth IRA is a qualified retirement account that allows contributions of up to $6,000 per year to grow tax-free. A distinction between a Traditional and Roth IRA is when the income from these two accounts is taxed.
With a Traditional IRA, you contribute "pre-tax" dollars into the account and take a corresponding tax deduction on your tax return. This can reduce your tax liability in the year the contribution is made. However, upon withdrawal from the Traditional IRA account, those amounts are taxed at ordinary income rates.
For a Roth IRA, the individual contributes "post-tax" dollars into the account and receives no beneficial adjustment on the tax return upfront. However, all withdrawals made from the account (past age 59 ½) are generally tax-free!
Therefore, taxpayers that expect to be in a higher tax bracket upon retirement can utilize the Roth IRA account as an important tax-saving tool.
Roth IRA Income Limitation
Unlike a Traditional IRA, high-income taxpayers are ineligible to make contributions to a Roth IRA account. These limits change yearly for inflation, but for 2022 the contribution begins to phase out at $129,000 Modified Adjusted Gross Income (MAGI) for single taxpayers or $204,000 for married taxpayers and is completely phased out at $144,000 and $214,000 respectively.
If higher earners would like to take advantage of the Roth IRA, there is a little-known legal loophole called the "Back-Door Roth." The Back-Door Roth has become an extremely popular, lucrative tax planning strategy.
"Backdoor" Roth - How it Works
Taxpayers that are usually ineligible to make Roth contributions due to income restrictions can instead make a non-deductible Traditional IRA contribution and convert the account balance into a Roth account.
Most retirement brokers can facilitate this conversion on your behalf, making the whole process stress-free.
Pitfalls to Avoid
This tax-saving strategy should be on every high-earning taxpayer's mind, but to ensure everything is done correctly, (and you don't end up paying excess taxes!) keep in mind these three common pitfalls when making the conversion:
Convert your Traditional IRA into a Roth ASAP. Any growth on the $6,000 contribution before the conversion is subject to income taxes. Doing the conversion as soon as the contribution is made helps maximize your tax-free growth.
The Five-Year Rule: Generally, withdrawing the principal from a Roth IRA is tax-free (remember "post-tax" dollars), but if you withdraw from your Roth account within five years of the contribution you may be subject to early-withdrawal penalties. If you reasonably believe that you'll need the money within five years, it's generally better to not contribute it to a Roth IRA ("backdoor" or otherwise).
The Pro-Rata Rule: When you convert Traditional IRA contributions into a Roth IRA, you cannot designate which contributions are getting converted. Instead, the IRS requires you to take a pro-rata share of all your Traditional IRA funds, which you have to include on your tax return as ordinary income.
Example – If you have a preexisting Traditional IRA with a value of $54,000 and contribute $6,000 to a new Traditional IRA with the goal of conversion to a Roth IRA. When you convert the $6,000 account into a Roth, the IRS will aggregate both the Traditional IRA accounts and then allocate the conversion between the two accounts (90%/10%). This will effectively subject $5,400 of the $54,000 to income taxation.
Generally, a taxpayer should not use the "Backdoor" Roth if they have other Traditional IRA accounts.
This lucrative workaround to the Roth IRA income limitations has been the subject of immense frustration for the IRS.
The Biden Administration included a provision in the Build Back Better Act (BBB) preventing Roth conversions for taxpayers earning more than $400,000 ($450,000 for married filers). The BBB still has to pass the Senate to become law, but this is a pretty strong indication that the Federal Government and IRS have the "backdoor" Roth in its crosshairs.
The "Backdoor" Roth is a powerful retirement planning tool that should be considered by high-earning taxpayers. To handle the conversion and the taxes properly, consult your tax professional.
Akiva Schreiber is a Tax Manager of Santa Monica, Calif-based Gerber Kawasaki Inc., an SEC-registered investment firm with approximately $2.2billion in assets under management as of 01/03/22. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which course of action may be appropriate for you, consult your financial advisor. No strategy assures success or protects against loss. Readers shouldn't buy any investments without doing their research to determine if the investments are suitable for their situation. "All investments involve risk and one should consult a financial advisor before making any investments. Past performance is not indicative of future results."
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice.