Backdoor Roth IRAs – A Sophisticated Yet Simple Retirement Planning Strategy
Jonathan Dunham, CFP®
Roth IRAs are one of, if not the most, powerful retirement vehicles available. The power comes from the tax-free growth, which allows you to withdraw the funds in retirement without any tax consequences. Sound too good to be true? The answer depends on your modified adjusted gross income (MAGI), which can be calculated by adding your adjusted gross income (AGI) plus certain deductions and tax-exempt interest. For 2020, if you are single with MAGI greater than $124,000 or married filing jointly and with MAGI greater than $196,000, your Roth IRA contribution limit is either phased out or eliminated. However, if you fall into either of those categories, don’t fret! In this article we’ll introduce a sophisticated planning technique that allows high income earners (and their spouses) to legally avoid the income limitations on Roth contributions by making a Backdoor Roth Contribution.
How do I make a Backdoor Roth contribution?
If you’ve made it this far, you’re probably anxious to find out. Once you’ve determined that you can’t contribute directly to a Roth (due to income limits) and confirmed you don’t have another type of IRA, making the contribution is quite simple. Here are the steps:
- Open two accounts: a Traditional IRA and Roth IRA account
- Make a non-deductible (this is key!) contribution to your Traditional IRA
- The 2020 contribution limit is $6,000. If you’re age 50 or over you can make an additional $1,000 contribution, bringing the total to $7,000
- You have up until the tax filing deadline (typically April 15th) to make IRA and Roth IRA contributions for the prior tax year, so if you didn’t do a Backdoor Roth for 2019 you can make two contributions in 2020. Under the CARES Act, the deadline for 2020 has been moved to July 15th
- Be sure to file a Form 8606 with your tax return
- Once the non-deductible IRA contribution is complete, transfer the cash from your Traditional IRA to your Roth IRA (known as a Roth Conversion)
- Invest the funds appropriately based on your time-horizon, risk tolerance and goals
- Watch it grow and enjoy tax-free withdrawals in retirement
So what’s the catch?
The only other way to fund a Roth IRA is by converting an existing IRA into a Roth IRA. There is no income limit for this transaction. If you currently have a Traditional, Rollover, or SEP IRA, however, you may have some taxable income when you convert the non-deductible IRA. For this reason, Backdoor Roth Contributions are less beneficial if you have existing regular IRAs, but should still be considered. If there’s a non-working spouse or a spouse without a regular IRA in the picture, they can still get the full benefit without taxable income for their contribution.
What else should I know?
The SECURE Act of 2019 brought about several provisions that make Roth IRAs even more favorable than their tax-deferred counterparts. One of the provisions eliminated the maximum age for contributing to Roth IRAs. Provided you have earned income, now anyone with wages can do a Backdoor Roth Contribution. This is a great benefit if you’re still working and want to boost your retirement savings.
Another provision extended the Required Minimum Distribution (RMD) age to 72 (previously age 70 ½) for Traditional IRAs. Roth IRAs, however, still do not have any mandatory withdrawal requirements for the original account owner (there are RMDs for beneficiaries, however).
Perhaps the most significant change of the SECURE Act is the elimination of the “Stretch IRA”, which allowed beneficiaries of IRAs to take RMDs based on their own life expectancy, and not that of the original account owner. With certain exceptions, non-spouse beneficiaries must now withdraw all the funds in an inherited IRA within 10 years from the death of the original account owner. This is a big blow to the tax-deferred growth of a Traditional IRA and the tax-free growth of a Roth IRA, but the Roth is even more appealing now since the RMDs are not taxed. A non-spouse beneficiary of a Roth IRA could leave the funds untouched in the account until the 10th year, maximizing its compounded growth potential, and then withdraw all the funds at once tax-free.
Regardless of one’s income or asset level, everyone should consider utilizing a Roth IRA as part of their retirement strategy. If the Backdoor Roth Contribution doesn’t apply to you or if you’d like to read more about the trade-offs between Traditional IRAs and Roth IRAs, Daintree’s Lauren Desforge covered this topic in To Roth or Not to Roth.