But Avoid These Potential Traps…

As an increasing amount of money continues to be moved from tax-deferred accounts to tax-free accounts, the IRS is noticing they’re losing out. According to revenue estimates, killing the backdoor Roth IRA would bring in around $385 million.1 So…the IRS is looking to slam the door on backdoor routes into Roth IRAs this coming year.

Before jumping into backdoor Roth IRAs, let’s first cover the basics of a Roth IRA. Roth IRAs just might be one of the best gifts given by the IRS. It is an individual retirement account in which you only pay taxes on contributions and all future growth is tax-free. If we take a look at tax rates throughout history, we can guess that taxes are going up. This is what makes the Roth IRA so attractive; why not pay taxes now when they are lower and avoid any taxes on all future growth? Seems like a win-win. However, there are limits to contributing to a Roth IRA.

Contributing to a Roth IRA

To contribute to a Roth IRA, you must have compensation and your modified adjusted gross income (MAGI) must be less than $193,000 if you’re married filing jointly, and under $131,000 if you’re single. If you’re under 50 years old you can only contribute up to $5,500, and if you’re over 50 the IRS gives you a $1,000 catch up. With these limitations come loopholes, which is where the backdoor Roth IRA comes in to play.

Roth Contribution eligibility

Backdoor Roth IRA

The backdoor Roth IRA is a strategy that has been used for higher income earners to take advantage of tax-free growth by making a contribution directly into a traditional IRA (step 1) and then converting it into a Roth (step 2).

Step 1: Traditional IRA Contribution

Similarly to contributing to a Roth, in order to contribute to a traditional IRA you must have earned income, but you must also be younger than 70 ½ at the end of the year for which you are making the contribution. The contribution limit for a traditional IRA is $5,500 with a $1,000 catch up if you’re over 50 years old.

There are no maximum income limits of any kind that can reduce someone’s ability to contribute to a traditional IRA. However, the taxation on the contribution may vary depending on certain circumstances. If you’re an active participant in an employer-sponsored retirement plan, your ability to claim a deduction for the contribution made to the traditional IRA will be phased out at the following income levels:

Phase-out range for IRA contribution deduction

The phase-out range for deducting an IRA contribution when the IRA owner is an active-participant  in an employer-sponsored plan are lower than the phase-out ranges for contributing to a Roth IRA. This means, if you’re phased-out of receiving a tax deduction for contributing to a traditional IRA, you still might be able to contribute directly into a Roth and enjoy tax-free growth as long as you’re under the Roth IRA contribution thresholds.

If you are not participating in an employer-sponsored plan, but your spouse is participating, there are still phase-out rules that will forbid you from claiming a deduction on the traditional IRA contribution. If this is the case, the ability to claim a deduction is phased out at the following income levels:

IRA Contribution Deductibility Spouse

These phase-out ranges are identical to the phase-out ranges to be eligible for a Roth IRA contribution. Therefore, in layman terms, if you’re over the Roth IRA contribution income limit threshold and either you or your spouse is an active participant in an employer-sponsored retirement plan, you will also be phased-out of claiming a deduction for your traditional IRA contribution.

Step 2: Converting Traditional IRA to a Roth IRA

Once you have made your contribution to a traditional IRA, the next step in the backdoor Roth IRA strategy is to convert the contribution to a Roth IRA. Based on the phase-out rules above, whether you received a tax deduction on your traditional IRA contribution will determine how your conversion will be taxed. Here are two examples:

Example 1:

Sally is an active-participant in an employer-sponsored plan and her income level is above the phase-out threshold so she is utilizing the backdoor Roth IRA strategy. She contributes $5,500 to a traditional IRA, but was unable to claim a deduction. Thus, the contribution is an after-tax contribution. When Sally goes to convert the money to a Roth IRA she notices the account has already posted gains and her $5,500 grew to $6,000. When Sally converts the $6,000 from the traditional IRA to the Roth IRA, only $500 will be taxed and the $5,500 she originally contributed will be tax-free since it was an after-tax contribution.

Example 2:

Bob would like to contribute to a Roth IRA, but his income level is above the threshold. Bob is self-employed and has never established a retirement plan for his business. If Bob contributes $5,500 to a traditional IRA he will be able to claim a deduction for the contribution and the contribution will go into his IRA as pre-tax funds. Later, when Bob goes to convert the money his account has risen to $6,000. Since Bob’s traditional IRA contribution was pre-tax, he will have to pay taxes on the full $6,000 upon converting the money into a Roth IRA. As a result, Bob and Sally will have both paid tax on a total of $6,000 in order to get the $6,000 into a Roth.

To sum it up, if you have no money in an IRA prior to a backdoor Roth IRA conversion, your tax bill will be the same whether you receive a deduction for the initial traditional IRA contribution or not. Things get a little trickier if you have existing IRA money. This is when the pro-rate rule comes into play.

The Pro-Rata Rule

When you have both pre-tax and after-tax money in a traditional IRA, you are not allowed to simply distribute or convert only the after-tax amount. The pro-rate rule is used to determine how much of a distribution is taxable when you have both after-tax and pre-tax dollars in your IRA. The rule states that, in general, an IRA distribution will consist of the same proportion of pre-tax and after-tax amounts as the IRA owner has in his or her IRAs. For the purpose of this rule, all traditional IRAs (including SEP and SIMPLE IRAS) are grouped as one giant IRA.

Pro-Rata Calculation

In order to determine the percentage of each IRA distribution that is not taxable, first total after-tax dollars in all of your traditional IRAs and divide it by the 12/31 balance of all your IRAs combined. Next, multiply that percentage by the amount of all IRA distributions (remember all of your IRAs are grouped as one). The calculated amount represents the tax-free portion, and the balance of the IRA distribution is taxable. Remember to include all distributions including conversions and any outstanding rollovers in that balance.

Pro-Rata calculation

Example 1:

Molly has a total of $100,000 in her IRAs. $5,000 out of the $100,000 is a post-tax contribution while the remaining $95,000 is pre-tax. Molly decides she wants to convert $5,000 to a Roth IRA. Upon converting the money, only 5% of the $5,000 would be tax-free.

Example 2:

Richard has an IRA with a pre-tax balance of $5,000. Later, Rick decides to open another IRA and makes an after-tax contribution with an additional $5,000. When Rick decides to convert any of that money into a Roth IRA, 50% of it would be tax-free while the other 50% would be taxed upon the conversion.

Will the Backdoor Roth IRA Go Away?

We don’t know for sure, but it wouldn’t surprise us if the IRS tried to cut this tax haven to get more money in the hands of Uncle Sam. Before 2010, Roth conversions had income restrictions, and as soon as they were lifted, traditional to Roth IRA conversions increased by a whopping 800% over the following year, from $6.8 billion to $64.8 billion, according to an IRA analysis.The IRS doesn’t like the fact that more people are taking advantage of this tax-advantaged loophole, which is why there are talks of getting rid of it completely.

What should you do?

If you qualify, take advantage of the backdoor Roth IRA this year and maximize your contributions because you may not be able to do it next year.

Source & Disclosures:

1 Ebeling, Ashlea. “Obama Budget Would Prohibit Backdoor Roth IRAs” Forbes, 2 Feb. 2015.
2 Bryant, Victoria & Gober, Jon. “Accumulation and Distribution of Individual Retirement Arrangements, 2010” IRS.gov.
Intended for educational purposes only and are not intended as individualized advice or a guarantee that you will achieve a desired result. Before implementing any strategies discussed you should consult your tax and financial advisors.