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The Backdoor Roth IRA

Roth IRAs are a unique and great way for individuals to save for retirement. You make non-deductible contributions to a Roth IRA, and after five years and attaining age 59½, all withdrawals of principal and earnings from the Roth IRA are tax-free. In addition, there are no required minimum distributions (RMDs) for Roth IRA owners, which will allow your Roth IRA the opportunity to continue to grow tax-free over the years for you and your heirs. Unfortunately, everyone is not permitted to contribute directly to a Roth IRA, as eligibility is restricted to individuals whose modified adjusted gross income (MAGI) is below a certain level. In other words, high income earners are generally restricted from making direct contributions to a Roth IRA. If this is the case, there is an alternative solution known as the “backdoor” Roth.

THE BACKDOOR ROTH IRA

One popular strategy that all traditional IRA owners are allowed to use, no matter how much money they make, is to complete a conversion (move assets from a traditional IRA to a Roth IRA). However, since all assets converted or contributed to a Roth IRA must be after-tax dollars, an individual will pay ordinary income tax on the untaxed portion of the converted amount for the year of the conversion. Here is how the backdoor Roth IRA works:
  1. Make a $6,000 ($7,000 if age 50 or older) non-deductible contribution for 2020 and/or 2021 to a traditional IRA.
  2. After a short waiting period (typically a day to a month or over a statement period), convert the traditional IRA assets to a Roth IRA.
Since a non-deductible contribution was made, the conversion was executed on a timely basis, and if no other pre-tax assets remain in your IRAs, the conversion is tax-free. The key from this point on is to maximize non-deductible traditional IRA contributions each year you (or your spouse if married filing jointly) have earned income and convert those contributions to a Roth IRA.

THOUGHTS TO KEEP IN MIND

  • Individuals must have earned income to contribute to a traditional IRA (even a non-deductible contribution).
  • The best candidates for the backdoor Roth strategy have no pre-tax IRA assets in any traditional, SEP, or SIMPLE IRA under their Social Security number (SSN). If the individual has pre-tax assets in an IRA as of December 31 of that year, a pro rata formula (portion of pre-tax and portion of after-tax) will apply upon conversion. The IRS does not allow an individual to convert only after-tax assets if his or her IRA(s) also contain pre-tax assets. A pre-tax rollover from a retirement plan to an IRA in the same calendar year as executing the backdoor Roth strategy will generally impact the taxation on the conversion.
  • If an individual has pre-tax IRA assets and wants to execute the backdoor Roth strategy, he or she can zero out his or her pre-tax IRA balance by doing a full conversion in one year and starting the backdoor Roth strategy in the next calendar year or can roll the pre-tax IRA balance to a 401(k) if the plan allows it.
  • 1099R and 5498 tax forms will be issued for the year of the non-deductible contribution and conversion.
  • IRS Form 8606 (non-deductible contributions) must be filed each year a non-deductible contribution is made or a conversion is executed. The IRS Form 8606 is filed on a per SSN basis even if married filing jointly.

While this strategy may be appropriate for you, it’s always recommended that you seek the aid of a competent tax advisor to assist you with tax advice and guidance.

Stifel does not offer tax advice. You should consult with your tax advisor regarding your particular situation as it pertains to tax matters.

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