Considering the advantages of back-door Roth IRAs, but want to learn more? Many individuals who are saving for retirement favor the benefits of Roth IRAs over traditional IRAs. This is because the former allows for both accumulation of account earnings and post-retirement distributions to be tax-free. In comparison, contributions to traditional IRAs may be deductible. Also traditional IRAs earnings are tax-deferred, while distributions are generally taxable. Anyone with compensation can contribution to a traditional IRA (although the deduction may be limited). However, not everyone is allowed to make a Roth IRA contribution.
Not everyone can reap the benefits of Roth IRAs
High-income taxpayers are limited in the annual amount they can contribute to a Roth IRA. The maximum contribution for 2021 is $6,000 ($7,000 if age 50 or older). However, the allowable 2021 contribution for joint-filing taxpayers phases out at an adjusted gross income (AGI) between $198,000 and $208,000. (This is an AGI between $0 and $9,999 for married taxpayers filing separately). For unmarried taxpayers, the phase-out is between $125,000 and $140,000.
Tax law includes a provision allowing taxpayers to convert their traditional IRA funds to Roth IRAs without AGI restrictions. But there is a price to pay for such conversions. That is, to the extent the contributions to the traditional IRA had been deducted, the conversion is taxable. Otherwise, the IRA owner would have a double benefit:
- the deduction when funds are contributed to the traditional IRA and,
- no tax when distributed from the Roth IRA in the future.
Although deductible contributions to a traditional IRA have AGI restrictions, nondeductible contributions do not. Thus, higher-income taxpayers can first make a nondeductible contribution to a traditional IRA. Then they can convert that IRA to a Roth IRA. Also known as a “back-door Roth IRA.”
Pitfalls of back door Roth IRAs
However, there is a big pitfall to back-door Roth IRAs, and it can produce unexpected taxable income. Taxpayers and their investment advisers often overlook this drawback. It revolves around the following rule; for distribution purposes, all of a taxpayer’s IRAs (except Roth IRAs) are considered to be one account. This means distributions are considered to be taken pro-rata from both the deductible and nondeductible portions of the IRA. The prorated amount of the deducted contributions is taxable. Thus, a taxpayer contemplating a back-door Roth IRA contribution must carefully plan for the consequences of this rule – before making the conversion.
There is a possible, although complicated, solution to this problem. Rolling over IRAs into other qualified retirement plans is permitted tax-free. An example of a qualified retirement plan would be employer retirement plans and 401(k) plans. However, a rollover to a qualified plan is limited to the taxable portion of the IRA. If an employer’s plan permits, a taxpayer could roll the entire taxable portion of their IRA into the employer’s plan. Thus, they would leave behind only nondeductible IRA contributions, which can then be converted into a Roth IRA tax-free.
Before taking any action regarding your retirement funds, please call this office at (360) 778-2901. We’d love to discuss the most tax beneficial options for your situation.
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