What Is the Backdoor Roth IRA? - Milestone Wealth Management
Backdoor Roth IRA

What Is the Backdoor Roth IRA?

As you probably know, there are income restrictions in qualifying for contributions to a Roth IRA. It’s something we’ve discussed before, but, just to recap, here are those income limits for 2016:

• Single filers – unless you make $117,000 or more in earned income, you are eligible for full contributions, after which only partial contributions are allowed. And you are ineligible for contributions if earning $132,000 or more.
• Married filers – reduced contributions begin at $184,000 in earned income, and are ineligible at $194,000.

Obviously, there are several benefits the Roth IRA has over a Traditional IRA. And I know that a lot of higher earners find these restrictions frustrating. But what few people exceeding these limits seem to know is that there is another way in to the Roth IRA… the “back door.”

Yes, despite its sneaky-sounding name, the backdoor Roth IRA is a perfectly legal strategy. Back in 2010, Congress passed legislation allowing those who exceeded income restrictions to convert other IRAs to a Roth IRA. And while this backdoor strategy is a complicated matter, I’m going to do my best here today to simplify the basics and, hopefully, give you something to think about.

How does the backdoor Roth IRA work?

Backdoor Roth IRA

Let’s say you earn $150,000 and are ineligible to contribute to a Roth IRA. What you could do is fund a Traditional IRA, first. So, you contribute $5,000 in after-tax dollars to your Traditional IRA, and, a little while later, you request your financial advisor convert that account to a Roth IRA. Because you have already paid taxes on the funds converted, you will only be taxed for any gains accrued over that short period.

What you have basically done here is fund a Roth IRA like millions of others saving for retirement, enjoying the same benefits they enjoy – only, because of your higher income, the law required you to take an extra step in the process. I’m not saying this extra step makes sense, but it is the law.

Now, it isn’t always as simple as this, either. And sometimes this backdoor isn’t one you would want to open. So, to get a better picture for what I’m talking about, let’s take a look at a recent example…

Meet Caroline

Caroline (not her real name, of course), came to me last month for a second opinion after a broker had encouraged her to utilize the backdoor Roth IRA strategy. The broker had told Caroline she earned too much to contribute through the front door, and he was correct. He advised her to contribute after-tax funds to a Traditional IRA and then convert to a Roth.

To that point, I agreed with the broker. Roth IRAs can provide a lot of wonderful advantages for high earners – tax-free growth, tax-free distributions, and no required minimum distributions (RMDs).
But here’s where I disagreed with the broker’s advice…

There’s a little something called the pro rata rule. This regulation states that all of an individual’s IRA plans will be looked at as one big IRA when using the backdoor strategy. What does that mean, exactly? Well, here’s what it meant for Caroline’s situation…

As a self-employed professional, Caroline owned a SEP-IRA that she had funded for a few years. For the sake of simple math, we’re going to say her SEP was valued at $95,000. Naturally, all of Caroline’s contributions to this account had been made with tax-deducted dollars. So, if Caroline would have followed the broker’s advice and contribute, say, $5,000 to a Traditional IRA, she would have been in for a big surprise.

You see, the IRS would have looked at her SEP IRA and Traditional IRA and saw $100,000. They would have seen that 95% ($95,000) of that $100,000 was the result of contributions and earnings that were made on a pre-tax basis. Even though she had paid taxes on the $5,000 in the Traditional IRA, $4,750 (95%) of those dollars would be taxed again. This is because under the pro rata rule the Traditional IRA’s, SEP IRA’s, as well as SIMPLE IRA’s all need to be aggregated together.

In other words, a backdoor Roth IRA for Caroline’s situation wasn’t nearly as great of an idea as her broker had claimed.

But I’m not Caroline – is the backdoor Roth right for me?

Backdoor Roth IRA

Now, just because the backdoor strategy wasn’t so great for Caroline doesn’t mean it’s always a bad move. If you have already funded another IRA (Traditional, SEP, SIMPLE) with pre-tax dollars, you may find the backdoor isn’t so welcoming.

However, I’ve met many people who have benefited from this strategy. But there are a lot of factors to consider – the pro rata rule being just one of them.

To find out if a backdoor Roth IRA is right for you make sure you speak to a qualified retirement specialist.