Back-Door Roth IRAs

Article Highlights:

• Roth IRA Contribution Limitations 
• Converting a Traditional IRA to a Roth IRA 
• Circumventing the Limitations 
• Back-Door Roth IRAs 
• Pitfalls of a Back-Door Roth IRA 
• The “All IRAs Are One” Rule 

Many individuals who are 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, earnings are tax-deferred, and distributions are generally taxable. Anyone who has compensation can make a contribution 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), but 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 who are 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 who is 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 his or her 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.

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