Save More for Retirement using Backdoor Roth IRA

There is still time to take advantage of the backdoor Roth IRA for tax year 2017. Contributions made to a IRA by the tax deadline (which this year is April 17, 2018) can be designated as for tax year 2017.

Higher income individuals often find they aren’t eligible to make tax-deductible contributions to a traditional IRA and aren’t eligible to make direct contributions to a Roth IRA. In this situation, a backdoor Roth can be a useful strategy for getting additional savings inside of a tax-preferred account.

Contribution Limits for 2018

Tax-preferred accounts — we’re talking specifically about 401(k)s and individual retirement accounts (IRA) — are a tax-efficient way to save for retirement. Yet, many do not know that they can save beyond the $18,500 maximum that can be contributed to a 401(k) in 2018.

Individuals can contribute up to $5,500 to an IRA in addition to any amount they contribute to their 401(k) plan.

When contributing to an IRA, individuals choose whether to contribute funds to a Traditional IRA, or to a Roth IRA, or to a combination of the two.

But wait a minute — aren’t people prohibited from contributing to a Roth IRA if their income is too high?

That’s right. But there’s a way around these income limitations.

The work around is called a backdoor Roth.

This strategy involves contributing funds to a non-deductible Traditional IRA and then converting those funds into a Roth IRA. This strategy works because there are no income restrictions on who can convert funds to a Roth IRA, even though there are income restrictions on who can contribute directly to a Roth IRA.

This article will explain who can benefit from a backdoor Roth IRA and provides an overview of the steps to take.

Who does the Backdoor Roth strategy apply to?

Before we get into the details of the backdoor Roth IRA, let’s start by explaining who can benefit from this strategy.

The backdoor Roth IRA strategy applies to people who have income falling within or above these ranges:

Table – Income Ranges in which People Become Ineligible for Roth IRA Contributions

Filing Status Modified Adjusted Gross Income
 Tax Year 2017 2018
Single or
Head of Household
$118,000 – $133,000 $120,000 – $135,000
Married Filing Jointly $186,000 – $196,000 $189,000 – $199,000

Married Filing Separately
and your spouse did not live with you at any time during the year

$118,000 – $133,000 $120,000 – $135,000
Married Filing Separately
and your spouse lived with you at any time during the year
$0 – $10,000 $0 – $10,000
  • People who have income falling within these ranges can make a reduced direct contribution to a Roth IRA, but not the full $5,500.
  • People who have income above these ranges are not eligible to contribute directly to a Roth IRA at all.

What does the Backdoor Roth IRA contribution allow me to do?

The backdoor Roth IRA strategy is an indirect route to get your personal savings inside of a Roth IRA account. This strategy allows you to get around the income eligibility restrictions for contributing to a Roth IRA. Since you are not allowed to contribute funds to a Roth IRA directly, you instead can take an indirect route by first contributing funds to a nondeductible Traditional IRA and then converting those nondeductible funds to a Roth IRA.

Why is this important?

This allows you to save another $5,500 inside a Roth IRA account.

Remember, there are income restrictions on making tax-deductible contributions to a Traditional IRA that are even lower than these limitations. So, this Backdoor Roth IRA technique is the best way to save an additional $5,500 in an IRA for retirement.

What is the benefit of a Roth IRA?

Investment earnings on funds sitting inside a Roth IRA can be withdrawn completely tax-free — as long as the funds sit inside the Roth IRA for at least five years and certain other conditions are met. That means you won’t pay tax on these funds again.

What if I already contribute to a 401(k) or 403(b) plan at work. Does a Backdoor Roth still help me?

A backdoor Roth pairs nicely with a 401(k) or 403(b) plan.

If you are already contributing the maximum amount to your 401(k) or 403(b) plan ($18,500 for the year 2018), the backdoor Roth provides a way for you to save an additional $5,500 towards retirement.

If you are not already contributing the maximum to a 401(k), you might want to look first at whether you can increase how much you save through the 401(k). Many 401(k) plans even have a Roth version, so you might have the option to make after-tax contributions to your 401(k) if that is your preference. Contributing Roth-style funds through your 401(k) is a much easier process compared to the backdoor Roth process. That’s because 401(k) plans do not have any income restrictions for making Roth contributions.

That being said, some people prefer IRAs over 401(k) plans because IRAs have a wider range of investment options, so that might be a reason to consider this strategy even if you are not contributing the full maximum to your 401(k).

What needs to be done before making a backdoor Roth IRA contribution?

If you already have a Traditional IRA, there are additional steps you need to do before making a backdoor Roth contribution. We refer to this as “clearing the decks.”

In order for a Roth conversion to be entirely tax-free, the individual needs to ensure that only funds representing the “nondeductible basis” are converted into a Roth IRA.

This causes a problem for clients who have pre-existing traditional IRAs with a combination of deductible and nondeductible funds. Deductible funds means the client took a deduction for their traditional IRA contribution. Nondeductible funds means that the client did not take a deduction for their traditional IRA contributions.

In this situation, we recommend that the person rollover the taxable portion of their traditional IRAs to a 401(k), 403(b) or similar group retirement plan. Doing so leaves only the non-taxable portion (consisting of nondeductible contributions) inside the traditional IRA.

These nondeductible contributions can then be converted into a Roth IRA at no tax cost.

This requires careful analysis, and so we recommend working with a tax advisor for those of you in this situation.

What are the steps to making a Backdoor Roth IRA contribution?

The actual mechanics of the Backdoor Roth IRA contribution are relatively straightforward.

First, some of you need to “clear the decks.” (See the section above.)

Second, you make a non-deductible contribution to a Traditional IRA. You do this by simply opening a Traditional IRA account at any financial institution and contribute up to $5,500 from your checking account.

Third, you tell your financial institution to roll over and convert funds from the Traditional IRA into a Roth IRA account. If you have an existing Roth IRA, you can use that account to receive the converted funds. There is no amount of time you need to wait before converting funds. We urge you to convert the funds before those funds have generated any investment earnings, as investment earnings are taxed as ordinary income when doing a Roth conversion.

Is it really that simple?

Pretty much. Just make sure to be careful if you have an existing Traditional IRA account, as we specified above.

Takeaways

  • The Backdoor Roth IRA contribution is a strategy for higher income people to get money into a Roth IRA.
  • While the steps to complete the transaction can be done yourself, we recommend first consulting a tax advisor.

 

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