As we approach the end of what has been nothing short of an interesting year, many high-paying individuals and couples are now taking time to reevaluate their retirement strategies. Given the income limits imposed for making direct contributions from the Roth IRA, creative savers often consider the Roth IRA back door, which involves first contributing money to a traditional or non-deductible IRA and then converting the contribution to a Roth IRA (therefore, without income tax) Before doing this – a tactic that we will examine below – it is absolutely imperative that you assess your entire IRA image from an aerial perspective to avoid a self-inflicted and unnecessary tax account.
What is a Roth IRA contribution from the funds?
As many retirement savers know, there are income limits associated with contributing to a Roth IRA in any given year. Since these limits apply primarily to individuals who earn more than $ 139,000 and couples who earn more than $ 206,000, this is a good problem. The desire to transfer money to the Roth, a vehicle that will never pay taxes again, is still worth fulfilling, as the importance of tax-free growth in a retirement plan cannot be underestimated.
A successful Roth IRA contribution has three steps. First, you will deposit money (maximum $ 6,000 in 2020 and 2021) in a traditional or non-deductible IRA. If you don’t have one, you can open one in less than five minutes at any of the main discount brokers: Vanguard, Fidelity, Interactive Brokers and the like. Once the money has been deposited in the traditional or non-deductible IRA, you can simply leave it in cash without taking another step to invest it.
Then, a few days later, you will want to convert the money you have just deposited into a Roth IRA. There should be an option on your account panel that says “Convert to Roth” or something similar – no need for paperwork or unnecessary phone calls here. By selecting the conversion option, you agree to transfer money from an account that normally contains (but not always) pre-tax money to an account that contains only after-tax money. Since your contribution in the first stage has already been taxed, there is no additional tax on the conversion to Roth.
The third step, which may seem obvious, but can be neglected, is to invest the money as soon as it reaches your Roth account. Your options are endless, but generally your Roth account is a great place for a pure equity or mutual fund ETF. Roth IRAs, since they contain money that will not be taxed again, are an ideal home for high-growth investments that you don’t expect to sell in the near future.
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What you need to do first
Before attempting this, assuming that you are indeed above the income limits for a direct contribution from Roth IRA, you will need to evaluate your entire IRA image. If you have any pre-existing IRAs, before taxes, including other traditional IRAs, rollover IRAs, SEP or SIMPLE IRAs, you will need to carefully consider your options before attempting a Roth backdoor contribution.
The reason for this is the famous “pro-rat rule”. If you have other IRAs before tax, when trying to convert your newly opened traditional IRA into a Roth account, the IRS will consider the conversion to have come from your entire IRA balance as of December 31 of the fiscal year. That is, your conversion will be taxed on a “pro-rata” basis, in relation to the other pre-tax IRA accounts you own.
For example, let’s say you have $ 100,000 of pre-tax cash in a SEP IRA. In an attempt to complete a successful Roth IRA backdoor contribution, you contribute $ 6,000 to a traditional IRA. After converting $ 6,000 to Roth, the IRS will see this as a taxable event. Your entire IRA balance is $ 106,000 and $ 100,000 (or 94.34%) of your balance has not yet been taxed. When you convert $ 6,000 to Roth, in this example, 94.34%, or $ 5,660, will be considered taxable income for you. In the 24% range, this will increase the federal tax due by $ 1,358.
A cure for the potential trap
There are many solutions here, but the most practical solution is to see if you can first include your existing pre-tax IRAs in your employer plan (a 401 (k) or 403 (b)) before trying the Roth IRA of the funds. This will allow you to eliminate your other IRAs and therefore eliminate the potential for improper or unexpected taxation. If you are self-employed and do not have access to an employer plan, you can consider opening a 401 (k) ground to receive potential funding from the IRA.
The Roth IRA backdoor is a great tool available to high-income people, but it is very important to see the conversion in the context of your total financial picture. This is a useful exercise, even if you don’t end up employing Roth’s backdoor strategy, and will allow you to plan conversions several years into the future.