Back-Door ROTH IRA StrategiesSubmitted by Desmond Wealth Management, Inc. on March 10th, 2016
There are several strategies for moving money into tax-free accounts, however, that may not always be the best choice for you. Having blended retirement accounts make sense when trying to minimize taxes and maximize sustainability.
How to Get Money Into a Tax-Free Account
There are three ways to get money into a tax-free, or ROTH IRA account.
- Make annual contributions.
- Convert your traditional IRA into a ROTH IRA
- Do both (with Back-Door ROTH contributions)
Many successful executives and small business professionals are high income earners. As a result, there are limitations to making annual contributions, not to mention there are tax consequences for converting an IRA into a Tax-Free ROTH IRA, but what is a Back-Door ROTH contribution? When your income is too high to make a traditional non-deductible ROTH contribution, you can still get that annual contribution into a Tax-Free ROTH through a back-door three-step process.
Three Steps for Making a Back-Door ROTH IRA
High income earners cannot contribute directly to a Roth IRA. However, they can contribute to a Traditional IRA then convert a Traditional to a Roth, which accomplishes the same thing as making that contribution directly into a ROTH account.
Step 1: Make Nondeductible IRA Contributions
If you have maxed out all of your deductible contribution options, then making a Non-deductible IRA contribution is the next step in saving for retirement. A non-deductible Traditional IRA is made with after tax dollars, and the earnings grow tax-deferred. On a ROTH IRA, the earnings grow tax-free. Free is better than deferred! If you leave your nondeductible contributions in a traditional IRA, a portion of your distributions representing earnings will be taxable as ordinary income upon their distribution in retirement.
So, the first step in converting into tax-free earnings, is to make a non-deductible Traditional IRA contribution. You can contribute $5,500 ($6,500 if you’re 50 or older) into a traditional IRA for yourself and another $5,500 (or $6,500 if 50 or over) into a traditional IRA for your spouse for 2015 (you have up to April 18, 2016 to designate these contributions for 2015).
Step 2: Convert Nondeductible IRA Contributions to a Roth IRA
Each year, after making your nondeductible contributions to your traditional IRA account, convert 100% of your contributions to a Roth IRA. Once your traditional IRA funds are transferred to your Roth IRA, none of the distributions from your Roth IRA will be taxable, including earnings, provided that you don't take any distributions for at least five years after you make your first Roth IRA contribution and you wait until you reach age 59-1/2 to take your distributions.
Step 3: Pay the Tax on the Converted Amount
Since the original contribution was non-deductible, taxes on the original amount are not taxable at the time of the conversion. You will only have to pay taxes on any gain in the account, which will be minimal if you convert shortly (see IRS Step Transaction below) after your contribution.
Watch Out For the Pitfalls
The backdoor Roth IRA conversion is a great strategy for transferring a nondeductible tax-deferred IRA contribution into a tax-free situation provided that (a) you have no other traditional IRA funds, or (b) the value of your other IRA's is less than or equal to the basis in your IRA accounts. If you have any other existing traditional IRAs, this can really screw up the conversion due to the pro-rata rule.
The Pro-Rata Rule
All rollovers from Traditional to Roth IRAs must be done on a pro-rata basis. So if you have existing Traditional assets (pre-tax) and you try to do a Back-Door Roth IRA by contributing to a non-deductible Traditional IRA (post-tax), you cannot choose to only rollover the non-deductible Traditional assets. Instead, any amount you rollover will be taken pro-rata from across all of your Traditional assets (deductible and non-deductible IRAs). This will cause a taxable event on the deductible IRA conversion. When changing or leaving a job, we generally recommend rolling your 401k into an IRA to take advantage of increased options and lower fees, however this is a good time to plan your ROTH conversion prior to creating a new non-taxable IRA that will have to be pro-rated.
IRS Step Transaction
The IRS considers to the 'spirit of the law' when looking at transactions made by taxpayers. If you contribute to a Traditional IRA then immediately convert it to a ROTH, the IRS may consider this as one (one step) transaction and disallow the ROTH contribution if your income limits for a ROTH are too high. We recommend that you create distance between the transactions by waiting until later in the year (or early the next) to make the conversion.
Planning is the key to creating and sustaining wealth, and proper placement of all your assets in tax-free, tax-deferred, and taxable accounts helps minimize taxes and increase growth.