A Roth IRA is a fantastic option for saving for retirement as it provides tax free withdrawals of both contributions and gains when taken in retirement. A majority of people are able to contribute $6,000 a year to a Roth or $12,000 for a married couple filing their taxes jointly ($7,000 and $14,000 respectively if over 50). However, there are limits to participation in a Roth IRA based on your income. This presents a problem for those in higher income tax brackets who also want the benefits of investing inside of a Roth IRA. Arguably, this is a better problem than the alternative but a problem nonetheless. So how does one reap the rewards of tax free growth even if they exceed the income limitations? The answer: back door Roth IRA contributions.
Before we get into what back door Roth contributions are, let’s first figure out whether or not they are necessary for you. For the year 2021, your ability to contribute[i]to a Roth IRA is phased out between $198,000 and $208,000 in modified adjusted gross income[ii]. This means that you can contribute a reduced amount if your income falls in that range and no direct contribution if your income exceeds $208,000. If that is the case, your only option for making Roth contributions is by way of back door contributions.
What exactly is a “back door Roth contribution”? A great question! While your income can limit you from making contributions to a Roth, it will not change your ability to contribute to a Traditional IRA (although it will change your contribution’s tax deductibility[iii]). This means that even if you exceed the maximum income level for participation in a Roth IRA, you can still contribute to a Traditional IRA. The next logical question is; why would that help you? Well, because of a little oddity in the tax code called a Roth IRA conversion. A conversion is exactly what it sounds like. It is the act of transferring or converting Traditional IRA contributions to a Roth IRA. This simple tool is at the heart of the back door Roth strategy. There are no income limitations on Roth conversions nor is there a limitation as to how many times a year you can convert contributions. The Traditional IRA then becomes a conduit for you to make contributions into the Roth IRA. The only catch is that if any part of your conversion comes from investment gains, you will be required to pay taxes on those gains. Your contributions however, would not be taxed in this scenario as they would be considered non-deductible, after tax contributions. When done correctly, this is an excellent strategy for those wishing to take advantage of tax free growth when they would not have been able to otherwise.
Another situation that can arise is when someone who is contributing to a Roth IRA ends up making more than they expected and as a result over contribute to their Roth IRA. At first this may seem like a big problem but in reality it is quite simple to resolve. If you find yourself having over contributed to a Roth IRA, you must recharacterize those contributions to a Traditional IRA. Basically, this is just the reverse of a Roth conversion. In order to avoid penalties from the IRS, you must complete the recharacterization on or before October 15th for tax year 2020 (assuming that you file your taxes on time on April 15th).
Whatever move you decide to make it is a good idea to discuss your investment options with your financial advisor and the tax ramifications with your CPA! As always, thanks for checking out the blog! This week’s song of the week is a reminder during these tumultuous times!
[i] https://www.irs.gov/retirement-plans/amount-of-roth-ira-contributions-that-you-can-make-for-2021
[ii] https://www.investopedia.com/terms/m/magi.asp
[iii] https://www.investopedia.com/roth-and-traditional-ira-contribution-limits-for-2021-5085118#:~:text=The%202021%20combined%20annual%20contribution,or%20eliminated%20at%20higher%20incomes.