Should I do a “Back-Door” Roth IRA contribution?
As we mentioned in our last commentary, there is still time to make contributions to certain retirement plan accounts for 2022.
One of the best options is to contribute to a Roth IRA. There is no tax deduction for a contribution to a Roth IRA (it’s made on an “after-tax” basis), but your contribution’s earnings/growth, if any, remain tax-deferred for as long as it stays in the Roth IRA. The earnings/growth can be withdrawn on a tax-free basis (as long as you keep in the Roth IRA initially for five years and reach age 59.5).
Roth IRAs are great to have in retirement to provide a tax-free pool of assets to withdraw from for regular or large, unexpected expenses. Using a Roth IRA for these purposes can limit your taxable income and help you avoid larger tax bills and Medicare premium surcharges later in life. This could come in handy, perhaps, for a surviving spouse who finds his or herself filing in the more consolidated individual income tax bracket, and who also isn’t really looking for any tax surprises.
Roth IRAs also avoid annual required minimum distributions (RMDs), and the income and income taxes they create, that apply to traditional retirement accounts starting in ages 73/75.
From an estate planning perspective, the tax-free status of Roth assets can be transferred to your heirs, which is better than leaving traditional retirement accounts where the income tax implications are passed on (and where taxes must be paid within 10 years in most cases).
Roth IRA Contribution Eligibility
In order to make a Roth IRA contribution, you need to have earned income (not passive or investment income) for the year in which you contribute. If you pass this test, then the next contribution eligibility hurdle is how much income you earn. Congress has limited the ability to make Roth IRA contributions for higher earning taxpayers through the following contribution phase-out limits:
If your modified adjusted gross income exceeds the upper dollar limit of the above phase-out, then you are not eligible to make a Roth IRA contribution.
For high earning taxpayers, this is where the “Back-Door” Roth contribution strategy comes into play.
The simplest explanation is that a Back-Door Roth contribution is where you make a contribution to a traditional IRA and then convert that traditional IRA contribution to a Roth IRA.
Step 1: Contribute to a traditional IRA
You can always make a non-deductible, after-tax contribution to a traditional IRA, as long as you have earned income. Most married couples can also make a contribution to an IRA for a non-working spouse as long as their combined compensation at least equals or exceeds their contributions.
The funding limit for an IRA in 2022 was $6,000 for those under age 50 and $7,000 for those 50 and older. For 2023, the IRA contribution limits are now $6,500 for those under age 50, and $7,500 for those age 50 or older.
Step 2: Confirm your pro-rata status
The IRS’s “pro-rata rule” is used to determine how tax-deferred money should be taxed upon withdrawal/conversion. It applies whether you are withdrawing $$ from your IRA to spend or converting traditional IRA assets to Roth assets.
Before you convert traditional IRA assets to a Roth IRA, you first need to total up the balance of all of your IRAs (traditional, SEP, Simple).
Next, divide any after-tax contributions (made directly by you to your IRA or to any company retirement plans you rolled over to an IRA) by your total IRA balance.
If the total of your IRAs is $100,000 and your after-tax contributions were $20,000, then the tax-free amount of any IRA distributions you take/conversions you make, is 20%.
If you withdraw $10,000 from any of your IRAs, then $2,000 would be tax-free and $8,000 would be taxable as ordinary income.
If you have no other IRA assets that have pre-tax contributions, then the tax-free amount of any additional contributions you make will be 100%. In this case, Back-Door Roth contributions are very appealing.
Step 3: Convert to a Roth IRA
After you make your non-deductible contribution to a traditional IRA, the next step is to convert the funds to a Roth IRA. This is done by transferring the funds from your traditional IRA to your Roth IRA. Often times we suggest waiting at least a few days’ time to allow for the funds to settle and be confirmed in the IRA account for recording purposes, and then proceed with converting that amount to a Roth IRA.
Unlike a typical Roth conversion (where you’ll pay taxes on any earning/gains and pre-tax contributions that you convert), the backdoor version can be a non-taxable event if you do it before any material earnings are generated – and where you don’t have other IRA assets that would make the pro-rata rule apply.
Step 4: Fill Out Form 8606 – recording the Backdoor Roth
This step can be managed by your CPA/accountant and the purposes is to properly record that the backdoor Roth was correctly reported to the IRS. Each spouse that completes a Backdoor Roth needs to complete for each year that a backdoor Roth contribution is made. When done correctly, the line on 15c and 18 on the tax form should read zero.
Step 5: Repeat Annually
We mentioned the benefits of Roth IRAs earlier. Roth IRAs are a preferred retirement savings vehicle and, for several reasons, can provide you with a lot more flexibility later on in life.
The Back-Door Roth contribution strategy provides a way around the income eligibility limits for higher earners to make Roth contributions annually. Once you’ve done a Back-Door Roth contribution, it can be a routine exercise every year.
Keep in mind the pro-rata rule and, if you have other IRAs, then one option may be to consider converting more of your IRAs to Roth and paying the taxes to do so. Another option could be, if your company retirement plan allows, rolling IRA assets into your 401(k) plan to take these IRA assets out of the pro-rata rule calculation.
As always, you should speak with your Wealth Advisor or tax professional about which options may make the most sense for you.
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