Back-Door Roth IRAs

Many individuals saving for retirement favor Roth IRAs over traditional IRAs because the former allows for both accumulation of account earnings and post-retirement distributions to be tax-free. In comparison, contributions to traditional IRAs may be deductible, tax-deferred earnings, and distributions are generally taxable. Anyone who has compensation can contribute to a traditional IRA (although the deduction may be limited). However, not everyone is allowed to make a Roth IRA contribution.

High-income taxpayers are limited in the annual amount they can contribute to a Roth IRA. The maximum contribution for 2021 is $6,000 ($7,000 if age 50 or older). Still, the allowable 2021 contribution for joint-filing taxpayers phases out at an adjusted gross income (AGI) between $198,000 and $208,000 (or an AGI between $0 and $9,999 for married taxpayers filing separately). For unmarried taxpayers, the phase-out is between $125,000 and $140,000.

However, tax law also includes a provision that allows taxpayers to convert their traditional IRA funds to Roth IRAs without any AGI restrictions. But there is a price to pay for such conversions: to the extent, the contributions to the traditional IRA had been deducted, the conversion is taxable. Otherwise, the IRA owner would have a double benefit – a deduction when the funds were contributed to the traditional IRA and no tax when distributed from the Roth IRA in the future.

Although deductible contributions to a traditional IRA have AGI restrictions (for those in an employer’s plan), nondeductible contributions do not. Thus, higher-income taxpayers can first make a nondeductible contribution to a traditional IRA and then convert that IRA to a Roth IRA. This is commonly referred to as a “back-door Roth IRA.”

BIG PITFALL: However, there is a big pitfall to back-door Roth IRAs, and it can produce unexpected taxable income. Taxpayers and their investment advisers often overlook this drawback, which revolves around the following rule: For distribution purposes, all of a taxpayer’s IRAs (except Roth IRAs) are considered to be one account, so distributions are considered to be taken pro-rata from both the deductible and nondeductible portions of the IRA. The prorated amount of the deducted contributions is taxable. Thus, a taxpayer contemplating a back-door Roth IRA contribution must carefully consider and plan for the consequences of this “one IRA” rule before making the conversion.

There is a possible, although complicated, solution to this problem. Rolling over IRAs into other types of qualified retirement plans, such as employer retirement plans and 401(k) plans, is permitted tax-free. However, a rollover to a qualified plan is limited to the taxable portion of the IRA. If an employer’s plan permits, a taxpayer could roll the entire taxable portion of their IRA into the employer’s plan, leaving behind only nondeductible IRA contributions, which can then be converted into a Roth IRA tax-free.

Before taking any action, please call this office to discuss strategies for making Roth IRA contributions or to convert existing traditional IRAs into Roth IRAs.