At long last the IRS has ended the debate over the legality of the “backdoor” Roth IRA. This subject has been widely debated in financial and legal circles for years. The subject was brought up again in December 2017 during the passage of the Tax Cut and Jobs Act and the good news for savers is that the debate is over- the backdoor Roth is legal.

The mechanics of the backdoor strategy can be a little confusing, so here’s a refresher:

Through the tax code the government encourages saving in traditional and Roth IRA’s.  However, “super saver” clients who have maxed out their retirement savings through work and are above certain income levels are excluded.  How much income is too much?  It may be less than you think:

*Assumes active participation by at least one person in retirement plan.

So, what are the options for the higher-income person who wants to save more for retirement?  Go in through the “backdoor”. 

Backdoor Strategy

Anyone with earned income can contribute to a traditional IRA; it is only the deductibility that is limited.  Furthermore, since 2010, Roth IRA conversions are no longer limited by income.  By opening a non-deductible IRA and then converting it to a Roth, the higher income client can then legally accomplish their strategy.

Before you rejoice, there are some thorny issues to consider.  The first is the IRA Aggregation rule. Essentially, if you have multiple IRAs (including traditional IRAs, SEPs, and SIMPLE IRAs) they are all treated as one account for tax purposes and the non-deductible portion is prorated over the total. This means you’ll be taxed once when you earn the income for the non-deductible contribution and then again when you make the conversion. Depending on your situation, this could lead to almost TWICE the taxes you’d pay had you not done the conversion. The process to calculate the potential tax consequences is complicated but depending on the size of the conversion, the tax amount owed could be quite large. In practice this stalls many people who have IRA rollovers from previous employers and would suddenly incur taxes on the conversion. Nevertheless, backdoor Roth conversions can still work in certain situations. We generally advise people to consult a CPA prior to making this decision.

In order to do a backdoor Roth conversion, you must be eligible to contribute to a traditional IRA. This means that you must have earned income or qualify for a spousal IRA and be under age 70 1/2 – the maximum age for IRA contributions.

Even though the strategy has been approved by the IRS, there are still quite a few stipulations and qualifications that must be met to execute the strategy effectively. We always recommend working with a CERTIFIED FINANCIAL PLANNER™ prior to making this decision.

What are the differences between a traditional IRA, a Roth IRA and non-deductible contributions?

In a word- taxes.

A traditional IRA is typically, although not necessarily, funded with pre-tax dollars. The money is allowed to grow on a tax deferred basis meaning you won’t owe a yearly tax bill on your income from dividends or on capital gains within the account. During retirement, when you make withdrawals from the account, you’ll need to pay taxes on the entire amount of the withdrawals at your ordinary income rates. Once you reach age 70 1/2, you will need to take “required minimum distributions” or RMDs. These are forced withdrawals and you will need to pay taxes on these.

A Roth IRA is funded with after tax dollars. Similar to traditional IRAs, the money is allowed to grow without any yearly tax bills. However, all the money withdrawn from a Roth after age 59 ½ is tax free.

Non-deductible contributions are made with after tax dollars. The money is allowed to grow on a tax deferred basis meaning no yearly tax bills- this is the advantage to a non-deductible IRA over a taxable account. However, unlike a Roth IRA, when withdrawals are made from a non-deductible IRA, taxes must be paid on the portion of each withdrawal that is over your contributions. There is no need to open an additional account if you already have a traditional IRA, however for accounting purposes it is often easier to open a new IRA to keep non-deductible contributions segregated from your traditional IRA. You will need to notify the IRS that you have made a non-deductible contribution each year you make non-deductible contributions. Custodians will not keep track of the total amount of deductible vs. non-deductible contributions. The burden of proof is on the taxpayer.

The tax calculation on withdrawals when there are non-deductible contributions can get quite complicated as aggregation rules apply. We recommend working with a CPA to ensure accurate calculation.

Are there any other advantages to a Roth IRA?

Yes. A Roth IRA is incredibly powerful because withdrawals made after age 59 ½ are always made tax-free. The account is funded with after-tax dollars (you are not allowed to deduct the contributions from your taxable income), but that’s the last tax you’ll pay on this money. Furthermore, a Roth does not have Required Minimum Distributions. If you don’t need the money in your Roth, you can continue to let the money grow tax free for as long as you wish.

Are there any estate planning benefits to Roth IRAs?

Roth IRAs can also be a very valuable component of a comprehensive estate planning strategy. Similar to traditional IRAs and 401(k)s, Roth IRAs can be passed on to named beneficiaries. Transferring a Roth to your heir does not require a will and the account will not have to go through probate (the legal process of “proving” a will in court). This speeds up the transfer process and helps preserve privacy for the deceased and the heirs. When a will gets probated, the process becomes public record. Allowing assets to transfer via named beneficiaries avoids this process altogether. Furthermore,  the account can continue to be transferred from one generation to the next through named beneficiaries. At present, there is no limit on the number of times the same account can be transferred. This is in contrast with trusts which cannot exist indefinitely. Keep in mind that passing a Roth account to a beneficiary will trigger mandatory distributions after the death of the original owner. The rules and options here can get quite complicated, so we recommend speaking with a CERTIFIED FINANCIAL PLANNER™ to review your options if you have an inherited Roth or are considering a Roth as part of a comprehensive estate planning strategy.

What is the best strategy to use? A Roth or a Traditional?

This is a difficult question to answer- it depends on the individual. Traditional IRAs and Roths both have contribution limits of $6000/year ($7000 if you are over the age of 50) in 2019. Therefore, it is difficult to reach a very large sum of money in these types of accounts without funding them from a rollover from another retirement account with higher contribution limits. However, in the case of a Roth, which is funded with after-tax dollars, income tax must be paid on the contributions.

For most people, the best comprehensive savings strategy is usually a combination of a traditional IRA and/or 401(k), a Roth IRA, and a taxable account. Having all three options gives most people the combination of tax advantages and flexibility to suit their needs.

What are the tax implications of a standard Roth conversion?

If a standard conversion is performed, the amount of the conversion will be included in your taxable income for the year. Let’s take the example of an individual converting $50,000 from a traditional IRA into a Roth who is currently in the 37% tax bracket. This $50,000 conversion would add $18,500 (37%) to her taxes for the year. To put it another way- she would have to set aside $18,500 from her income just to pay the taxes on the Roth conversion. However, if she was able to time the conversion so that it occurred during a year where she had less income and was in a lower tax bracket, this would allow her to perform the conversion at a more desirable tax rate. But remember- once the money is in the Roth, she will never owe taxes on it again- so by performing the conversion she is able to permanently exclude this money from taxation.

The decision on which account(s) to open is challenging even for experts because most individuals are trying to accomplish multiple goals with their savings. Furthermore, the tax consequences of a poorly executed backdoor Roth conversion can be severe. Making these decisions should be part of a comprehensive financial plan. We always recommend working with a CERTIFIED FINANCIAL PLANNER™.