An individual retirement account can be a useful retirement savings tool to supplement your 401(k) or a similar employer-sponsored plan. A Roth IRA affords the opportunity to make qualified withdrawals tax-free in retirement, which can work in your favor if you're in a higher tax bracket.
Not everyone can contribute to a Roth IRA, however. The Internal Revenue Service bases eligibility on your modified adjusted gross income (MAGI) and tax filing status. For 2020, contributions phase out for single filers with a MAGI of $124,000 or more and married couples filing jointly with a MAGI of $196,000 or more.
There is, however, a workaround to the income limits. A backdoor IRA offers high earners a chance to enjoy the tax benefits of a Roth, but it may not be right for every investor.
How a Backdoor Roth IRA Works
A backdoor Roth IRA involves converting traditional IRA contributions to a Roth IRA. You can use an existing traditional IRA, or open a new account specifically for the conversion. Once you've converted from traditional to Roth assets, you'd be able to enjoy the tax-free withdrawal status of that account. You do, however, have to be aware of any tax liability you might incur as a result of the conversion.
Tax Liability When Converting to a Roth IRA
Traditional IRAs are funded with pre-tax dollars. Depending on your income, these contributions may be deductible or non-deductible. So why is that important when you're converting to a Roth?
The IRS doesn't allow you to dodge your tax liability. Typically, you'd pay taxes on these funds when you withdraw them in retirement, at your ordinary income tax rate. If you're converting a traditional IRA that's composed of deductible contributions, you'd have to pay the tax due on those contributions and their earnings at the time of the conversion.
But what if you're converting nondeductible contributions? That's when things can get a little tricky. If your traditional IRA includes only non-deductible contributions, you'd only pay taxes on any amount above your tax basis. If you have traditional IRAs that include both deductible and nondeductible contributions, however, the IRS will calculate any taxes due on the conversion on a pro-rata basis, using the value of all your IRAs.
That means if you have $300,000 in traditional assets and contribute $5,500 to a non-deductible IRA, you couldn't just transfer the non-deductible portion, even if it's in a separate account. You'd have to treat that $5,500 as partial conversion of your total IRA assets for tax purposes.
Minimize Your Conversion Tax Liability With a 401K
If you're in a higher tax bracket and you're converting a significant amount of traditional IRA funds, the result could be a large tax bill in the year you convert. Fortunately, there is a way to minimize some of the tax liability.
For tax purposes, the IRS doesn't include 401(k)s under the aggregation guidelines. If you have a mix of both deductible and non-deductible traditional IRA assets, you could roll the deductible portion into your workplace retirement plan if that's allowed. That would leave you free to convert the non-deductible portion of your IRA to a Roth without triggering the pro-rata tax rule.
Converting Traditional IRA Assets With a Backdoor Roth
A backdoor Roth IRA can yield some important tax benefits, and it's important to think it through carefully. For example, what tax bracket do you expect to be in when you retire? If you anticipate being in a higher bracket than you are now, the tax savings you could realize through Roth IRA withdrawals may outweigh any tax liability you incur now as a result of the conversion. On the other hand, if you've accumulated a substantial amount in a traditional IRA, converting could be costly.
Remember also that you can't withdraw converted funds out of a Roth IRA for at least five years without incurring a penalty. If you tap the funds before then, you'd owe a 10 percent early withdrawal penalty unless you're age 59 1/2 or older. It's important to understand your timeline until you think you'll need those funds.
If you're not planning to tap IRA assets for some time, a backdoor Roth offers yet another benefit. With traditional IRAs, you're required to begin taking minimum distributions based on your life expectancy at age 72. Roth IRAs have no required minimum distributions, meaning you can leave the money to grow as long as you like. That, paired with the ability to make those withdrawals without tax, could tip the scales in favor of converting traditional IRA assets.
Baird does not offer tax advice. Please consult with your tax professional.