Is A Backdoor ROTH IRA Right For You?

You hear on Podcasts or on some YouTube Video that if you don’t qualify for a ROTH IRA there is a way you can do a ROTH using a loophole in the tax code that allows you to get the advantages of a ROTH IRA.  So what is it and is it right for you?

You are “allowed” to make a ROTH IRA Contribution for 2020 if your AGI is below $196,000 if you file as married filing jointly or if you file as head of household. The AGI limit for a single filer is below $124,000. For 2021 those income limits went up to $198,000 and $125,000.  If your AGI is greater than those numbers, you can not contribute to a ROTH IRA. This is where a backdoor ROTH could be beneficial.

So your income exceeds the limits and you have participated in your employer-sponsored plan… how can you do a backdoor ROTH IRA?

The first step is to open a Traditional IRA and make a contribution.  This contribution would be non-deductible due to income and plan participation.  Since this contribution would then be, in fact after-tax money, there would potentially be zero to minimal tax implications to step two.  Some tax and investment professionals recommend creating a trail, insisting you to wait until the next month to convert your non-deductible IRA to a ROTH.  The value difference between contribution and conversion, if any, stems from the growth of the contribution. Any growth would be taxable on conversion date.

One point to remember before we discuss potential pitfalls is that contributions made before April 15, 2021 can be coded as 2020 contributions, but the conversion would be coded as 2021 conversion since that is the tax year it took place.

As with any loophole, if not careful there can be pitfalls.  

• The first pitfall crops up if you have a large amount of your assets in an IRA.  For example, you have $1,000,000 in all pre-tax IRA’s.  You contribute $7,000 to a new IRA and then a month later convert that IRA to a ROTH IRA.  Your Tax Free Return of Basis  would be  $49.00.  Using the formula $7,000/$1,000,000*$7,000 = $49.  At this point you would be better off looking at converting some of your other assets to a ROTH.
• The second pitfall occurs if you have no other IRA’s, but all of your pre-tax savings is in your 401(k) or 403(b).  So you decided to go through the process of opening a Traditional IRA and then converting your IRA to a ROTH.  But later in the year you decide it is time to retire and move your retirement plan to an IRA.  You now have triggered the pitfall.  Say your retirement plan is $1,000,000 and that is moved to an IRA.  That dollar amount is added to the formula we used in the first example.  $7,000/$1,000,000*$7,000=$49.  So now not only is the tax free portion of your conversion $49, but the difference $6,951 is added to your gross income.

A backdoor ROTH might be right for some people and help create a pool of tax-free savings. One must be careful not to create pitfalls and make sure that it truly will help you in your planning and savings.

If you have questions about this or other ways to save for your retirement, please do not hesitate to reach out to your team here at Darden Wealth Group.