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What is a Backdoor Roth IRA?

Earlier this month, we discussed the benefits of contributing to a ROTH IRA directly from an early age. However, if your income is above the phase-out limit, you’re out of luck for making a direct Roth contribution. But you can still make a contribution to a traditional IRA, and that’s where the backdoor Roth strategy comes in.

A Backdoor Roth IRA allows people with high incomes to sidestep the Roth’s income limits.

A Backdoor Roth IRA essentially lets you convert your nondeductible traditional IRA contribution to a Roth IRA, even if your income is too high to make a Roth IRA contribution.

You are eligible to contribute to a Roth IRA at any age as long as you or your spouse, if filing jointly, have earned income and your modified adjusted gross income (MAGI) is at or below the phase-out limits shown below.

Roth IRA contribution phase out limits 2022

Tax Filing StatusMaximum AGI for Full Roth ContributionAGI Limits for Partial Contribution
Single, head of household, or married filing separately IF you didn’t live with your spouse during the year$129,000Between $129,000 and $144,000
Married filing jointly or qualifying widow or widower$204.000Between $204,000 and $214,000
Married filing separately IF you lived with your spouse at any point during the year$0$10,000 or less

Backdoor Roth IRA Contribution Limit

The IRA contribution limit for 2022 is $6,000 per person, or $7,000 if you are 50 or older. So if you want to open an account and then use the backdoor IRA method to convert the account to a Roth IRA, that’s the maximum you can contribute.

Is now a good time for Roth Conversion?

If the value of the IRA investments has declined (which is the situation most clients are in right now due to stock market), you can convert the IRA assets at that lower value and benefit from a correspondingly lower tax liability. When the market rebounds, the gain on the converted Roth assets will be tax-free. 

For example, let’s say you have a pre-tax traditional IRA worth $100,000, you like the investments and when the entire market goes down, the value drops to $65,000. You can save money by converting $65,000 rather than the original $100,000.

Taxes and Backdoor Roth IRAs 

If you’re converting from a traditional IRA that already has earnings on investments, you can still do the backdoor Roth IRA conversion, but you’ll owe tax on the earnings. 

There are two “five-year rules” to keep in mind. The first says that you can’t access your funds in the first five years after a Roth IRA conversion without penalty. That means that when you convert, you start the five-year clock. Typically, you can withdraw your contributions without penalty, but for conversions, you must observe the five-year rule. The exceptions to this are if you become disabled or pass away and leave your account to heirs. 

The second five-year rule dictates that you can’t withdraw Roth IRA earnings unless your first contribution was made more than five years prior, even if you’re over age 59 ½. You can withdraw your original contributions any time but must wait five years to withdraw any earnings in your account without additional taxes or penalties.

Pro Rata Rule

The pro rata rule comes into play when you have both pretax and after-tax money in a traditional IRA.  If now you want to convert your non-deductible IRA to a Roth, you’d have to pay income tax on a portion of this. To figure out your tax liability, take your after-tax contributions and divide them by the total value of all your IRAs.

Here’s an example to help you understand how it works:

If you have $5,000 worth of nondeductible contributions and $15,000 worth of deductible contributions from back when your income allowed you to contribute to a deductible IRA, only 25% (5,000/20,000) of your backdoor Roth conversion will be tax-free. So, 75% of the money you convert is taxable.

Those who don’t already have a pretax IRA can contribute after-tax funds and then convert them to a Roth without a pro rata rule event.

As you can see, the backdoor Roth conversions can be tricky. We recommend you speak with your financial advisor if you want to use the Backdoor Roth IRA strategy.

Questions?

As always, should you have questions about this or any other topics related to your personal or business situation, please contact us at any time.

To read more articles from our Estate Planning team, please click here.

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