Yahoo Finance The Power of the Backdoor Roth IRA
The Roth IRA is an incredibly powerful retirement account. It allows participants to make contributions with money that has already been taxed. Those funds will compound for decades without the gains being taxed, and then the account owner can take tax-free withdrawals in their retirement years. The earlier you start to make these contributions, the more you will be able to sock away, and the more tax-free income you will have in retirement.
The government sets income limits for Roth IRA eligibility. The ability to contribute to a Roth IRA begins to phase out when your modified adjusted gross income is above $116,000 if you are single or $183,000 if you are married and filing jointly. If you earn more than $131,000 for individuals and $193,000 for couples, the IRS no longer allows you to participate in a Roth IRA.
However, there is another way for high income folks to take advantage of a Roth IRA. A "backdoor" Roth IRA allows you to get your money into a Roth IRA in an indirect manner. In this case, participants can first contribute their money to a non-deductible traditional IRA, then roll it into a Roth IRA. Unlike a deductible traditional IRA or a Roth IRA, the non-deductible traditional IRA has no income limit for contribution eligibility. Anyone with earned income can contribute to a non-deductible traditional IRA, regardless of their income level.
The backdoor Roth IRA in action. Doing a backdoor Roth IRA may not always be as simple as it looks on paper. When you convert a traditional IRA to a Roth IRA, you are changing the tax status of those assets. Funds in a traditional IRA are tax-deductible, meaning you make the contributions before you ever pay taxes on that income. This gives you a tax break now, but you are required to pay taxes on the withdrawals in retirement.
Roth IRA contributions, on the other hand, are made with money that has already been taxed, and the funds will not be taxed when withdrawn in retirement. The government needs to collect taxes somewhere in the chain, so in order to change the tax status of your retirement account, you will need to pay taxes on the funds when you convert a traditional IRA to a Roth IRA. For example, if you convert a deductible traditional IRA worth $10,000 to a Roth IRA, you pay taxes on the full amount at the time of the conversion.
But things are different when you have a non-deductible traditional IRA. Contributions to a non-deductible traditional IRA were never classified as tax-deductible, so you can convert them to a Roth IRA without paying additional taxes on those funds. But there is one major caveat: the pro rata rule.
The pro-rata rule can change everything. The pro-rata rule requires you to lump all your traditional IRA funds in one bucket (both deductible and non-deductible), and pay a proportionate amount of taxes on the amount you are converting to a Roth IRA. In the previous example, we converted $10,000 from a deductible traditional IRA into a Roth IRA. Taxes would be due on the full $10,000.
Now let's say you want to convert $10,000 to a Roth IRA, but $5,000 of that is from a deductible traditional IRA, and the remaining $5,000 is from a non-deductible traditional IRA. You would have to pay taxes on the $5,000 that was in a deductible traditional IRA, but you wouldn't have to pay additional taxes on the amount from the non-deductible IRA.
Unfortunately, you don't get to pick and choose which funds you wish to convert. The IRS lumps them all into one bucket, requiring investors to pay taxes on a proportionate amount of their total traditional account, even if they only convert a portion of the account. This is important to keep in mind if you have a large amount of funds in a deductible traditional IRA (including rollover IRAs), or are considering rolling over assets from a 401(k) or another retirement account into a traditional IRA.
How to handle the pro-rata rule. If you have a substantial amount of funds in a traditional IRA, it may still be possible to contribute to a backdoor Roth IRA without having to pay a lot of taxes. One way around that would be to roll all of your deductible traditional IRA funds into another retirement account, such as a 401(k), if your employer allows this. Doing so moves your deductible IRA funds into a 401(k) plan where they maintain the same tax benefits, but give you a clean slate to work with.
As you can see, there can be several factors that affect your ability to contribute to a backdoor Roth IRA. Because this can get complicated, you may wish to consult with a financial planner or tax professional before taking action.
Ryan Guina is the founder of CashMoneyLife.com .
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