A “backdoor IRA” strategy is a method to get around the income limits that preclude higher income earners from opening a Roth IRA. The strategy involves opening a non-deductible traditional IRA and converting it to a Roth IRA at a later date.
To understand why this is desirable, it is best to contrast three types of IRAs.
- Traditional IRA – A traditional IRA is funded with pre-tax dollars and is tax-deductible assuming certain qualifications. You pay taxes on the earnings and also on the pre-tax contributions when they are withdrawn. Contributions must stop in the year that you reach age 70-1/2, and you must start taking minimum distributions at that point.
There are no income limits to start one, but the tax deductibility may be limited if you are eligible for an employer-based retirement plan.
- Roth IRA – A Roth IRA is funded with after-tax dollars and is therefore not tax deductible. However, there is a tax benefit in that you do not pay taxes on the investment earnings within the account if you meet certain requirements (basically, having the account established for at least five years and taking withdrawals after age 59-1/2). You can continue to contribute to Roth IRA’s after age 70-1/2 if you have earned income and do not have to take minimum distributions at any time.
The Income limit (Modified Adjusted Gross Income or MAGI) in 2014 is $129,000 for single status and $191,000 for married filing jointly. Beyond that point, you cannot contribute to a Roth IRA.
- Non-deductible IRA – A form of traditional IRA that you open if you cannot meet the deductibility requirements – for example, if you are contributing to an employer-based plan and make above a certain income amount.
It is funded with after-tax dollars, and it is therefore not tax-deductible. You will still pay taxes on the earnings, but since you have already paid taxes on the contributions, they are withdrawn tax free – assuming you file the correct paperwork with the IRS (Form 8606).
There are no income limits to start a non-deductible IRA.
Relatively recent rules allow anyone to convert a traditional IRA to a Roth IRA, regardless of income level – thus the backdoor IRA concept was born. A higher wage earner can open a non-deductible IRA with after-tax dollars and get the benefit of tax-deferred growth, and then convert the funds over to a Roth IRA to get the benefits of the freer policy on contributions and minimum distributions – and potentially tax-free future earnings from that point on.
However, financial experts suggest caution using this strategy, and some discourage it outright. Why? You must be extremely careful in determining your tax liability.
In the case where you have only one IRA to convert and all of the contributions to the IRA are non-deductible, it is relatively straightforward. The only taxes you will pay upon conversion are on the earnings from your non-deductible IRA.
However, your tax liability is determined on the aggregate of all of your IRAs.
So if you have a separate IRA that is a traditional deductible IRA, or the IRA you wish to convert contains normal tax-deductible contributions as well as non-deductible ones, your tax liability is calculated via an IRS formula – not just off the straight percentage of deductible contributions.
The tax-free percentage is the total non-deductible contributions divided by the sum of the value of all IRA accounts plus the amount you want to convert. In essence, this makes the backdoor IRA impractical if you already have a large traditional IRA funded with deductible contributions.
Even more problematic, the ruling is so recent that the penalties for incorrectly calculating the taxable amount are not obvious. The five-year limit has not been reached yet, so nobody has been able to take anything out of a backdoor IRA yet. Who wants to be the first to find the boundaries of a penalty within the IRS? You don’t, and we don’t either.
The backdoor IRA may be a valid strategy for high-income earners to get the benefits of a Roth IRA – but it is best applied when there is only one IRA involved with only non-deductible contributions involved. Otherwise, seek professional assistance, and tread carefully.
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