Written By: Chris Waclawik
Roth IRAs have been a great way for individuals to save for retirement since they were created. With a Roth IRA, no tax benefit is received on the front end. However, once money is contributed to the account, the owner does not have to pay tax on any earnings. Additionally, once the money is withdrawn, none of the withdrawals are included in taxable income. With years of tax-free growth, even relatively small initial contributions can grow significantly.
For 2016, individuals can contribute up to $5,500 per year to a Roth IRA, or $6,500 for contributors who are 50 years old or older. Roth IRA contributions are limited to taxpayers who make less than $194,000 a year if their filing status is married filing jointly or $132,000 if single. However, taxpayers may be able to contribute to a Roth IRA if their income is above the threshold by making “backdoor” Roth contributions.
The way backdoor Roth contributions work is fairly straightforward. An individual can contribute up to the $5,500 or $6,500 limit to a traditional IRA. Then, the taxpayer can immediately convert contributions to the traditional IRA into a Roth IRA. This works because there is no income limit on contributions to a traditional IRA, and there are no income limits on who can complete a conversion from a traditional to a Roth IRA.
If the taxpayer has no existing traditional IRAs, the process works well. The taxpayer will not receive an income tax deduction for traditional IRA contributions, but since this contribution must be included in income upon conversion, it doesn’t matter.
The biggest obstacle to the backdoor Roth is if the taxpayer already has
made traditional IRA contributions and has received a tax deduction for those contributions. If a taxpayer already has a traditional IRA worth $95,000 made entirely with tax deductible contributions, makes a $5,000 non-deductible contribution, and then converts $5,000 to a Roth IRA, the conversion will be applied to the entire IRA pro rata. Thus, only 5 percent (or $250) will not be taxed. The other $4,750 of
the conversion will be taxable income. All existing IRAs in the taxpayer’s name are aggregated when completing a conversion.
In some cases, it may be possible for the taxpayer to elect to roll all existing traditional IRAs into an employer’s 401(k) or other qualified retirement plan. If the employer allows this, the taxpayer will have no IRAs remaining, allowing the backdoor Roth conversions. However, employers are not required to accept rollovers from IRAs, so it is advisable to check with plan sponsors to determine if this option is available before a plan is put in place.
Another issue for practitioners to be aware of is that the backdoor Roth contribution is regularly on the list of tax “loopholes” that lawmakers discuss closing. While no legislation has been passed, in 2015, congress closed a number of filing strategies for Social Security after years of discussions with no action.
For the time being, backdoor Roth contributions are available and they are a great way for high-income taxpayers to save a little extra for retirement.
Chris Waclawik, AFC®, CFP®, is an associate advisor with Merriman Wealth Management in Seattle. Prior to that, he was a senior tax advisor for H&R Block, as well as a tax advisor for the United States Army in Daegu, ROK. He has also has worked as a financial counselor for the Army Community Service and the Army Career Alumni Program.