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The Backdoor Roth IRA

July 29th, 2016

Think you make too much money to contribute to a Roth IRA?

Try the back door!

By MARCUS ASHWORTH, CFP® and CASEY SULLIVAN, AIF®

 “You make too much money to contribute to a Roth account”.  For years we have heard our clients tell us that is what their respective tax advisors have told them.  From our clients’ perspective, most CPA’s seem to have no problem reminding them of that every year.  The advice he/she is giving you is correct, if your income for 2016 will be over certain income thresholds ($132,000 for single tax payers and over $184,000 for married couples filing jointly).  However, there is another way of getting some money invested in a Roth IRA Account.   The strategy is referred to as the ‘Back Door Method’ or Back Door Roth IRA.

 There are no income disqualifications in converting an IRA to a Roth IRA, unlike making a contribution to a Roth.    The tax benefits of a Roth over a Traditional IRA can be significant over time.   Roth distributions after the age of 59 ½ can be tax free, plus you’re not forced to take out distributions called Required Minimum Distributions (RMDs) at 70 ½, as you are with a Traditional IRA.  Traditional IRA distributions are normally always taxed at ordinary income rates.  In essence if you can make a traditional IRA contribution (deductible or non-deductible) then you are eligible to convert the IRA to a Roth regardless of your income and regardless of your current participation in a work based retirement plan like a 401k.  This strategy does come with some caveats.  For instance, Internal Revenue Codes, like IRC 408 (d)(2) and 408 (d)(3) which pertain to aggregation rules, along with a rule called the step transaction doctrine are complicated and need to be appropriately addressed.   Space does not permit me to include details on these potential challenges, so working with a CPA and or Financial Advisor knowledgeable with this strategy is highly advisable.  Working with our clients and their CPAs, we have successfully employed this strategy in recent years for high wage earning clients who want the benefits of both tax free growth and withdrawals.  In its simplest form here’s how it works:

Say for instance you’re eligible to make a Traditional IRA contribution.   The only eligibility requirements for a Traditional IRA are A) you must have taxable income and B) you must not be over the age of 70 ½.   Whether or not your IRA contribution is tax deductible or not is determined by your income and whether you are currently contributing to another retirement plan thru work (see your tax advisor for more on this).   Either way if you have the money to kick the $5,500 this year (over the age of 50 it’s $6,500) to a Traditional IRA you may be able to convert that IRA to Roth IRA after the Traditional IRA contribution is made.  Some suggest waiting a month before making the conversion in order to avoid one of the pitfalls called the “step transaction doctrine.”  

If you make a deductible Traditional IRA contribution, then you will pay taxes on the amount you convert to a Roth IRA.  If you make a nondeductible IRA contribution (assuming you avoid the aggregation rules noted above) then you will not pay any tax on converting the money to a Roth! Some pundits of this strategy have suggested the back door Roth could constitute a potential ‘step transaction’ when the two steps are executed in close succession.  However, one of our country’s leading IRA experts and author on the subject, Ed Slott and Company, disagree and believe the Back Door Roth IRA is a viable strategy regardless of how long a client waits between their two steps.   This is not a transaction a robo-advisor or stock broker is likely to be able to assist you with.  As such we highly recommend working with a CPA, CFP® or wealth management firm who specialize in this area.

Next time your accountant tells you, “you’re not eligible for a Roth,” tell him or her, “let’s try the back door Roth IRA”.