IRAs are a simple and easy way to build your retirement nest egg. There is minimal paperwork and the deadline for contributing is the due date for filing your tax return (e.g., April 18, 2022, for 2021 tax returns). There are two main types of IRAs: Traditional IRAs and Roth IRAs. Traditional IRAs are funded with pre-tax money. This means you receive a tax benefit upon contributing the funds, but the earnings are taxed as current income when withdrawn after age 59½. Furthermore, IRA balances are subject to a required minimum distribution (“RMD”) beginning at age 72. Roth IRAs are essentially the opposite. The account is funded with after-tax money, so there is no tax benefit upon contribution, however, the earnings grow tax and penalty free when withdrawn after age 59½. Roth IRAs are not subject to a RMD at age 72, which allows the account balance to continue to grow as long as you are alive.
Roth IRAs have wonderful advantages for investors; however, they do come with rules and income restrictions. If your 2021 modified adjusted gross income exceeds $208,000 (married filing jointly) or $140,000 (single), you are not allowed to contribute directly to a Roth IRA (In 2022 the amounts are $214,000 and $144,000). However, there is a simple strategy known as a “backdoor Roth IRA” that will allow you to contribute to a Roth IRA even if your income is too high.
With the backdoor Roth IRA, instead of contributing directly to the Roth IRA you must first make a nondeductible contribution to an IRA. (The maximum amount that can be contributed to an IRA or Roth IRA is $6,000 or $7,000 if you are aged 50 or older). Once the contribution has been made, you can then convert the account to a Roth IRA. There are no income restrictions when making a conversion. Although contributions are subject to deadlines and contribution limits, there are no such limits with respect to conversions. You can convert a traditional IRA to a Roth IRA anytime during the year and in any amount.
With the backdoor Roth IRA, the idea is to convert the contribution as soon as possible (or prior to investing the contribution). This will result in no tax consequences since the amount converted equals the amount of the nondeductible contribution. If the amount converted is greater than the amount of the nondeductible contribution, the excess is taxed. For example, if you make a nondeductible $6,000 contribution and decide to invest the money prior to making the conversion and at the time of conversion the value of the account increases to $6,500, the $500 of gain will be taxed.
As long as you have no other traditional IRA accounts, the backdoor IRA strategy should be tax free (unless the money is invested before conversion). If, however, you have an existing traditional IRA, it gets a bit more complicated. The IRS rules require you to combine all of the IRA accounts to determine tax consequences. This means you cannot only convert after-tax contributions. All conversions are treated as pro rata distributions from each separate IRA account and to determine your tax liabilities, all your IRAs are lumped together as one account. This is known as the pro rata rule which can be illustrated as follows: Assume Theo has an IRA of $94,000 of pre-tax contributions and makes a nondeductible IRA contribution of $6,000. His plan is to convert this $6,000 contribution to a Roth IRA. After the contribution, the total value of his combined IRAs is $100,000 and since 94% represents pre-tax contributions ($94,000/$100,000) $5,640 (94% x $6,000) is taxable on conversion and only 6% of the conversion is nontaxable.
Backdoor Roth conversions are an excellent way to build up your after-tax retirement money. However, they’re not right for everyone, as they can come with tax consequences. Discuss this strategy with your investment advisor to determine if it is right for you.