You May Have “Backdoor” Options Available Beyond Traditional and Roth IRAs
Last week we discussed making contributions to a traditional IRA and a Roth IRA. To recap, the deductibility of the traditional IRA and the ability to contribute to a Roth IRA are both limited based on AGI (adjusted gross income). For those individuals above the income thresholds, do not be discouraged. As a high-income earner, you still have the ability to contribute to an IRA and convert the contribution to a Roth IRA (amounts limited to $5,500 or $6,500 for those over 50). However, the contributions to an IRA are not income tax deductible (as obvious as it is, this is what we call a non-deductible IRA) and the Roth IRA conversion has an extra step with some considerations (this is called the “backdoor” Roth IRA).
With the non-deductible IRA, contributions go in after-tax and like the traditional IRA remain tax-deferred until withdrawn. The difference between a distribution from a deductible IRA and a non-deductible IRA is the taxable amount upon withdrawal. Recall, with a traditional IRA the entire withdrawal amount is subject to ordinary income tax. On the other hand, non-deductible IRAs maintain a cost basis, which is the amount contributed and not awarded the income tax deduction. Since these dollars go in after-tax, at withdrawal the distribution is a combination of the basis (after-tax contributions) and gains/earnings. Since you already paid tax on the contribution amount the portion attributed to the contribution is not taxed as income. The balance of the withdrawal is considered gain and is subject to ordinary income tax.
For the “backdoor” Roth IRA, things are a little more tactical and an additional item needs to be considered. Since you (as a high-income earner) cannot contribute to the Roth IRA directly, you first must contribute to the non-deductible IRA as we discussed above. Once in the non-deductible IRA, contributions and earnings, at any point, can be converted to a Roth IRA. This additional step of putting funds into the non-deductible IRA and converting is the “backdoor” way of contributing to the Roth IRA given the specific income limits for a direct Roth IRA contribution. Often, once a contribution is made, a full conversion to the Roth IRA should be executed. An immediate conversion to a Roth IRA will keep gains from accruing and being taxed as ordinary income upon conversion.
One thing to keep in mind with the “backdoor” Roth IRA contribution and conversion are balances currently held in other IRA accounts. The IRS does not allow individuals to cherry pick which IRA balances are converted to the Roth IRA (ex. traditional IRA vs. non-deductible IRA balances). Balances in a traditional IRA can diminish the advantages of converting the non-deductible IRA because of a potential taxation on the non-deductible IRA conversion amount. With that said, it is best explained through an example:
If an individual has a traditional IRA with $20,000 (an income deduction was taken) and they contribute $5,000 to a non-deductible IRA, with the intent of converting to a Roth, the total IRA balances would be $25,000. The $5,000 conversion would have to consider the total of $25,000 to see how much can be converted income tax free. The individual would take the $5,000 non-deductible contribution and divide it by $25,000 to get 20%. 20% of $5,000 is $1,000, therefore, the $1,000 would be tax free and the remaining $4,000 would be taxed as income to the individual. The basis of $4,000 does carry forward through your tax return, however, this is where we would recommend you work with an accountant to maintain the basis as it is carried forward on the IRA as well as considering your personal tax situation. Additionally, cash flow needs to be a consideration when making this conversion since any income tax liability will need to be paid out of pocket to avoid the use of IRA money to pay for the tax.
With the “backdoor” Roth IRA conversion, currently there are no limitations on income like there are on direct Roth IRA contributions. Keep in mind, the ability to convert IRA accounts (deductible and non-deductible) is available to everyone, however, it is important to look at your current situation to determine if it is right for you. If you would like to learn more about the non-deductible IRA and “backdoor” Roth IRA contributions and if they are good planning decision for you, feel free to contact me or your advisor here at D.B. Root so that we can discuss.
Steve Kohler is Managing Director of DBR Advisory Services at D. B. Root & Company, a Pittsburgh-based wealth management firm. If you would like to contact Steve please e-mail him at firstname.lastname@example.org or call 412-227-2800. Read bio…
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