A backdoor Roth IRA is a great saving and earning vehicle where the contributor can circumvent the income limits on a Roth IRA by converting a traditional IRA to a Roth IRA.
Roth IRAs are a great vehicle for creating a substantial retirement fund because you are using after-tax money, but you get to withdraw that money and any gains you earn tax-free which ultimately saves the investor a ton of money.
The problem for higher earners like physicians, is there are income limits that make the investor ineligible for investing in a Roth IRA. The income limits for 2016 is as follows:
- For single filers – $132,000
- For married filing jointly – $194,000
To overcome the eligibility limits on a Roth IRA, the investor can contribute to a traditional IRA (regardless of income), and then convert the traditional IRA to a Roth IRA without being subject to the income eligibility limits and then enjoy the tax savings that the Roth IRA provides.
This may sound illegal to those of you who may have an issue with being outside of the rules, but it’s not. In 2010, our government dropped the income limits attached to the IRA conversion which created this wonderful Roth IRA loophole, thus, the backdoor Roth IRA.
Although the backdoor Roth IRA is perfectly legal, there are certain steps that must be taken in order not to run afoul of the law. (Please note you can continue contributing to a Roth IRA if your annual income is below the 2016 eligibility limit listed above.)
1. Put some money in a traditional IRA account.
If you don’t already have a traditional IRA account, you’ll need to create one and fund it. If you are opening a traditional IRA in order to do a backdoor Roth IRA, you can fund your account with after-tax dollars and not worry about paying taxes on that money and the interest it will earn in retirement.
2. Convert your traditional IRA to a Roth IRA.
The administrator of your traditional IRA will offer to give the instructions and paperwork required for the conversion.
3. Pay the taxes on any pre-tax contributions if you had an existing traditional IRA.
Since only after-tax dollars can fund your backdoor Roth IRA, if you are converting an existing traditional IRA that has been funded with pre-tax dollars, you will need to pay the taxes on those contributions just like anyone else who invests in a Roth IRA.
4. Pay the taxes on any gains that were in your traditional IRA before the conversion.
If your pre-existing traditional IRA balance includes some investment gains, you will need to pay the taxes on those gains when you convert it to a Roth IRA and report this on next federal tax return.
Certainly, the biggest advantage of the Roth IRA is that once it’s funded with after-tax dollars, it’s never taxed again. When it comes time to withdraw your funds, neither the contributions or the earnings are taxable. And, if at any time you find yourself in a financial pinch, you can withdraw some of your contributions totally tax-free. To withdraw earnings, however, the account holder must be at least age 59 ½ and the account must have been opened for at least 5 years, but even with this rule, there are still ways to make qualified withdrawals if you don’t meet the minimum age and account limit.
Like with any investment, there are always pros and cons that should be considered before taking action.
Pros of the backdoor Roth IRA:
- Using the backdoor strategy, high-earners can legally circumvent the income eligibility requirements and take advantage of the significant tax advantages.
- Withdrawals that are tax free are worth considerably more to someone in a high tax bracket than they would to someone in a lower tax bracket.
- Opening an account is straightforward and can be accomplished on your own or with a little help from your account administrator.
- The backdoor Roth IRA eliminates your need to re-characterize your direct Roth contributions if your income happens to exceed the limit in your Roth IRA.
Cons of the backdoor Roth IRA
- Although the steps to creating your backdoor strategy are basic and easy to follow, it’s possible to commit an error that will be difficult to correct. (if you’re not sure, contact your administrator)
- You must pay taxes on your contributions to an existing IRA and any gains when you convert to a Roth IRA.
- Although most financial legislation changes normally apply to transactions going forward, it is possible that if the backdoor (loophole) is closed by the Feds, existing accounts may be affected.
The pro-rata rule
When an investor owns other traditional IRA assets that have not been taxed, the taxes you’ll owe on the conversion will depend on the ratio of IRA assets that have been taxed compared to those that haven’t been taxed. If the old non-taxed assets are much greater than the new IRA that consists of taxed assets, most of the new IRA assets will become taxable when converted to a Roth IRA. (Discuss with your administrator.)
Recharacterize when needed
If you find that your backdoor maneuver proves regrettable because you had other non-taxed IRA assets, and, therefore, your backdoor IRA had higher tax liability than you expected, you have the option to recharacterize the conversion. This allows you to switch the newly converted Roth assets back to traditional IRA status, and thereby undoes the conversion and the resulting tax liability.
Conversion of an IRA containing long-term assets
Be careful when converting a traditional IRA that contains long-term assets that have greatly appreciated, such as stocks or a stock fund; the conversion may likely trigger a very high tax liability which was not previously anticipated before the conversion.
Waiting to take action
Although the President’s attempt to remove the loophole that created the backdoor conversion failed in 2016, it is likely that more attempts will be made and thus, time is of the essence for taking advantage of the backdoor that is currently open.
- 2016 contribution limits
- 2016 income limits
- Tax treatment
- Withdrawal rules
- Additional benefits
$5,500; $6,500, if age 50 or older.
Single filers with modified AGIs of less than $132,000 (phase-out begins at $117,000); married filing jointly with modified AGIs of less than $194,000 (phase-out begins at $184,000).
No tax break for contributions; tax-free earnings and withdrawals in retirement.
Contributions can be withdrawn anytime tax and penalty free. After 5 years and age 59 ½, all contributions and earnings can be withdrawn tax-free. No withdrawal requirement during account owner’s lifetime; beneficiaries can withdraw distributions over many years.
After account is five years old, withdrawals up to $10,000 can be received penalty-free to cover expenses for first-time home purchase.
$5,500; $6,500, if age 50 or older.
Anyone with earned income can contribute but tax deductibility is based on income limits and participation in employer plan
Tax deduction in year of contribution; ordinary income taxes owed on all withdrawals
Withdrawals are penalty free beginning at 59 ½. Distributions must begin at age 70 ½; beneficiaries are taxed on inherited IRAs.
Contributions reduce taxpayer’s AGI, potentially qualifying then for other tax incentives. Up to $10,000 penalty-free withdrawals for first-time homebuyers, but taxes charged on distributions.
We can easily calculate a “what if” scenario using an online IRA calculator in order to make accurate comparisons.
Current age: 30
Age of retirement: 70
Annual contribution: $5,500
Expected rate of return: 7%
Current tax rate: 25%
Retirement tax rate: 15%
Married filing jointly
Total contributions: $240,000
Roth IRA total at retirement: $1,218,718
Traditional IRA + tax savings: $1,071,910
If, in the above scenario, your AGI reached or exceeded $194,000, during your working years you would have lost your eligibility to contribute to the Roth IRA unless you successfully converted using the backdoor rule currently in effect.
Although you can create your backdoor Roth IRA on your own, if you’re like most people, you may want to confirm that you’ve set it up correctly and paid any outstanding taxes that may have been required. Some of the most highly rated administrators are as follows:
- TD Ameritrade
- Charles Schwab
- Merrill EDGE
When you consider investing in any type of IRA, what you pay in fees can have a significant impact on your net available funds at retirement. Many investors go it alone and save significant dollars but do not have access to the experience and advice of an investment professional at firms such as TD Ameritrade, Vanguard, or Charles Schwab.
In today’s investment environment, many of the online brokers offer no-fee IRAs and unless you are using services provided by a specialty “self-directed” IRA shop for assets such as precious metals and hedge funds, you shouldn’t be paying any service or custodial fees.
If, however, you prefer that your contributions are invested in stocks or mutual funds, you are likely to be charged a fee for each trade or transaction. The good news is that there are many players in the financial investment industry and the resulting competition for your business is greater than ever. All of the major players (see above) offer competitive rates for trades and annual account management.
Taking the appropriate time to complete your due diligence online is likely to save significant dollars over the long-term and offer you better net results when retirement finally arrives.
For now, even though President Obama attempted to prevent Roth conversions of after-tax dollars in an IRA, which would have led to the demise of the backdoor Roth IRA, it appears that high-earners who like the strategy of sinking money into their Roth IRA through the backdoor, are safe for at least another year. If you are a candidate because your annual income is approaching and will soon reach the Roth IRA eligibility limits, don’t wait, contact an investment advisor today or begin your research if your preference is to go it alone.
Colin is the Founder & CEO of LeverageRx, an online lending and insurance marketplace for doctors. Colin has over 10 years of experience in financial services and is a licensed life and health insurance agent.