After the 2017 Tax Cut and Jobs Act, advisors have been utilizing a little-known provision in the tax code blessed by the IRS. It is called the Back-Door Roth contribution, and it lets high-income earners still get some funds into a Roth IRA, even if they make well over the upper end of the income limit.
How do back-door Roth contributions work?
- You make a non-deductible contribution to a Traditional IRA. Generally, when you contribute to an IRA, you get to deduct those funds you put into the account from your taxable income. For back-door Roth purposes, it is important that the funds are non-deductible, as they add “basis” to your IRA account.
- The “basis” in the IRA is then eligible to be converted to a Roth account. Because the initial contribution was non-deductible, you owe no tax on the amount you have converted over to your Roth IRA.
It is that easy. By adding an extra step, someone making millions of dollars a year in earned income can contribute to a Roth IRA.
So why doesn’t everybody do it? To be eligible and make sense, there are a couple criteria:
1. You need to have no funds in a tax-deferred IRA, or at least none that are stuck in an IRA.
a. The IRS counts all your tax-deferred IRA accounts as effectively being one. This means if you have a “nondeductible IRA” and a “Traditional IRA”, they assume they are one and the same. Some taxpayers have a 401(k) that will accept their after-tax IRA dollars, which is a way to empty your IRA so you can do a back-door Roth. So, you either need a 401(k) or no IRA dollars to be able to take advantage.
b. Side note: some planners recommend contributing even if you DO have IRA dollars already. That means you only get to complete the first half of a great idea, and only getting to do the first half leads to some adverse tax consequences. By adding after-tax dollars to an IRA, you are causing all the growth of that money to be tax deferred. That may sound okay, until you realize that it could grow and be taxed at preferential capital gains rates instead of being taxed as ordinary income, which is what happens to all IRA withdrawals. So instead of setting up a taxable account and potentially paying 0%, 15% or 23.8% in tax on the growth, you contribute to an IRA and can pay up to 37% in tax.
2. You need to have the cash flow necessary for a back-door Roth contribution to make sense.
a. Each taxpayer under 50 may contribute up to $6,000 in 2020 to a back-door Roth; those over 50 get to contribute $1,000 extra for $7,000 total. For the added hassle and complication, if you are only able to fund a few hundred dollars into a back-door Roth, it probably is not worth it.
3. You need to have funds you can save for retirement.
a. Jumping through all these hoops and contributing to these accounts only make sense if you don’t need the cash any time soon. There can be some adverse tax consequences to pulling the funds out too early, so these contributions really need to be long-term. If you have a lot of need for cash in the short-term (maybe sending kids to college or buying a house), it would be much better to contribute your money to a taxable brokerage account and invest in a tax-efficient manner so that your money is available whenever you need it.
The back-door Roth can be a great tool if it fits your situation, but it really is not for everybody. Before jumping through the hoops, it is best to sit down with a fee-only financial planner who can help determine your situation, long and short-term goals, and your money needs.
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