The Roth IRA is a powerful tax-saving tool, allowing taxpayers to invest retirement funds and withdraw their appreciated balance tax-free in retirement. Congress, however, has imposed limitations on contributions to Roth IRAs. For example, in 2022, taxpayers may only contribute up to $6,000 to a Roth IRA ($7,000 for individuals aged 50 or older). However, beginning in 2010, high-income taxpayers have been able to utilize the backdoor Roth IRA strategy to get around these income limitations.
How the Backdoor Roth IRA Works
Before 2010, taxpayers with adjusted gross incomes of $100,000 or more were excluded from converting traditional IRAs to Roth IRAs. The Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA) repealed this income limitation on Roth IRA conversions beginning in the 2010 tax year.
This means that a taxpayer whose income exceeds the income limitations on directly contributing to a Roth IRA may, rather than contributing directly to a Roth IRA, fund a traditional IRA—typically with a nondeductible contribution—and convert the balance to a Roth IRA.
This practice is referred to as the backdoor Roth IRA strategy. If you implement a backdoor Roth IRA strategy, be sure to file Form 8606 with your tax return to report it.
Who Benefits From a Backdoor Roth IRA?
Taxpayers whose income precludes them from directly contributing to a Roth IRA may benefit from a backdoor Roth IRA.
Tax and Other Considerations to Make Before Investing
While the backdoor Roth IRA offers taxpayers, high-income taxpayers, the opportunity for tax-free growth in a Roth IRA that would otherwise not be possible for them without paying the 6% annual excise tax that would likely outweigh any tax benefits obtained, there are some considerations to make before utilizing this strategy.
The Pro-Rata Rule
Taxpayers considering utilizing the backdoor Roth IRA strategy should keep in mind the pro-rata rule if they have existing traditional IRA balances for which they took tax deductions in previous years on the contributions. In this case, a portion of the taxpayer’s backdoor Roth IRA conversion will be taxable, even though they are not deducting their current-year contribution to their traditional IRA—the amount they are converting in whole or in part to a Roth IRA.
To determine the taxable amount, the taxpayer must divide the year-end amount of their traditional IRA balances on which they took tax deductions for contributions in previous years by the total year-end amount of their traditional IRA balances.
The result of this calculation is the percentage of the amount converted that is taxable.
The Five-Year Rule
Another thing to keep in mind is the five-year rule. Before taking distributions, taxpayers must wait at least five years from the time they convert a traditional IRA to a Roth IRA. Otherwise, they may be subject to an early distribution penalty.
So if you are nearing retirement and anticipate needing to tap the money you would otherwise use to convert to a Roth IRA within the next five years, a backdoor Roth IRA may not make sense for you.
When Might It Be a Bad Idea?
Keep in mind that if you are eligible to take a deduction for traditional IRA contributions this year, utilizing the backdoor Roth IRA strategy means that you are, essentially, trading your tax deduction today for tax-free distributions in retirement.
If you are in a high tax bracket now but anticipate being in a low tax bracket in retirement, this tradeoff may not be worth it in your situation, and the backdoor Roth IRA may be a bad idea.
This article is meant to be a general overview before making any decisions about resource allocation. It is wise to consult with a qualified tax professional about your particular situation.
Seniority is published by Finance of America Reverse LLC. The views expressed in this publication are those of the author alone and do not necessarily reflect the views and opinions of Finance of America Companies. This article is intended for general informational and educational purposes only and should not be construed as financial or tax advice. For more information about whether a reverse mortgage may be right for you, you should consult an independent financial advisor. For tax advice, please consult a tax professional.
