By Susan E. S. Howe, CPA | Howe Advisory
For taxpayers seeking to maximize their tax-advantaged retirement savings options, “back-door” Roth IRA contributions are frequently touted as an option. There are things you should know before engaging in this strategy. If a financial adviser is suggesting the strategy, be sure he or she works with you on understanding any tax consequences.
Let’s start with why Roth IRA contributions might be desirable. Advantages of a Roth IRA are as follows:
- If you satisfy certain requirements, qualified distributions are tax free.
- You can make contributions to a Roth IRA after you reach age 70 ½.
- You can leave amounts in your Roth IRA as long as you live (no required minimum distributions).
You cannot deduct contributions to a Roth IRA on your taxes as you can in limited circumstances for contributions to a traditional IRA. But the tradeoff is that all the earnings on Roth distributions are tax free as long as you satisfy the requirements, which generally are leaving the funds in the account for at least five years and attaining the age of 59 ½ before withdrawing.
Before thinking about a “back-door” contribution, first establish if you are eligible to make a standard Roth IRA contribution. For tax year 2017, if you are single and your modified adjusted gross income (MAGI) is less than $118,000, you have no restrictions on making a Roth IRA contribution within the limits established by the IRS. (For most taxpayers, MAGI is the sum of all income before any deductions or exclusions.) If you are married and filing jointly, and your MAGI is no more than $186,000, you are also eligible for a full Roth IRA contribution. There are phase-out ranges, but for single taxpayers with more than $133,000 or married taxpayers with more than $196,000 in MAGI, Roth contributions are not allowable. The only option to get funds into a Roth IRA would be the conversion strategy.
The back-door Roth IRA strategy is a perfectly allowable way for higher income taxpayers to get money into Roth IRA accounts without paying tax on the conversion. There is, however, an important caveat. A back-door Roth contribution involves first contributing money to a traditional IRA, which is available to all taxpayers, regardless of income limit or whether they are also covered under an employer-sponsored retirement plan. The funds are then immediately converted to a Roth contribution. This conversion is the allowable mechanism to get the funds from the traditional IRA into the Roth IRA since any taxpayer, regardless of income limit, can convert their IRA. The condition for this conversion is that tax must be paid on any amount converted that is in excess of the taxpayer’s basis in the traditional IRA. In a case where a hypothetical contribution of $5,000 is placed in a traditional IRA in a nondeductible transaction (because of higher income or coverage under an employer retirement plan) and then immediately converted to a Roth, the basis in the converted funds is $5,000 and the conversion is tax free. Voila! The $5,000 is now in the Roth IRA, and it will grow and be distributed tax free.
However, beware the trap for the unwary. If you have funds in any other traditional IRA set up in previous years, the conversion of $5,000 is considered to come from all the IRA funds, not specifically from the $5,000 you contributed this year. In most cases, that means at least some of the conversion will be taxable. If you have low or no basis in all your other traditional IRA accounts, the conversion will be considered to be drawn proportionally from all the accounts, and some (or even most) of it could be taxable. The conversion might still be desirable, but if you are in a high tax bracket, it may not be a desired strategy if you were expecting to pay tax on your IRA withdrawals later at a lower, post-retirement tax rate.
To summarize, beware of the back-door Roth conversion if you have any funds in traditional IRAs other than funds you intend to contribute and instantly convert. Work with a CPA who understands the choice and can advise you on the tax consequences beforehand. A phone call prior to acting can save both time and a surprise tax bill.
Susan E. S. Howe, CPA, is principal of Howe Advisory in Strafford, Pa.