The American retirement system is confusing to say the least. 401(k)’s, Traditional IRA’s, Roth IRA’s. It can be pretty annoying to keep track of it all. Here’s a primer on how it all works if you’re a little rusty.
Today we’re going to focus on the humble IRA. To recap, an IRA can be opened up as two versions: the Traditional IRA and the Roth IRA.
|Traditional IRA||Roth IRA|
|Contributions are…||Pre-tax Dollars||Post-tax Dollars|
|Investments Grow Tax-Free||Yes||Yes|
|Withdrawals are…||Taxed||Not Taxed|
Between the two accounts, you are limited to contributing a maximum of $5,500 per year.
These are similar to Canada’s RRSP and TFSA accounts, except Canada’s versions are a lot less restrictive (no goofy age restriction, for example).
The problem with the Roth is that the IRS actually limits your ability to contribute if you make too much money. Here are the 2018 Roth IRA contribution tables.
So if you’re married and together you make over $199,000, it looks like you’re outta luck. No Roth IRA contribution for you. Boo.
Actually, no. I’m just joshing ya. There’s a loophole. There’s always a loophole.
While there’s an income limit for direct Roth IRA contributions, the limit doesn’t apply for money transferred over from a Traditional IRA to a Roth IRA. This is known as a Roth IRA conversion. Hence, the ability to make a sneaky-but-still-totally-legal contribution commonly called a Backdoor Roth IRA contribution.
Here’s how it works.
First, you open up a Traditional IRA.
Then you make a $5,500 ($6,500 if you’re older than 49) contribution and you elect NOT to take the $5,500 deduction on your income taxes. Why would you do this? Because if you deduct the contribution you will have converted post-tax money into pre-tax money, and when you covert it in the next step, you’ll be hit with a tax bill.
Finally, you perform a Roth IRA conversion that converts your entire Traditional IRA into a Roth IRA.
Voila! You have just performed a Roth IRA conversion by…ahem…entering through the…back door.
Before you actually do this, there are a few caveats you should be aware of.
In order to report a non-deductible contribution to your IRA, as well as report the conversion to the Roth IRA, you have to file Form 8606 to the IRS when you submit your taxes. If you don’t, it’s generally not the end of the world since you can file it retroactively, but as with most things IRS-related, you generally don’t want them to be pissed off at you. So remember: Form 8606! File it!
Also, if you have an existing Traditional IRA this gets somewhat more complicated due to something called the IRA Attribution Rules.
Here’s how it works.
If you had no existing IRA, making a non-deductible $5,500 contribution to an empty account sets the “basis” for that account to $5,500, meaning the amount of post-tax money that’s in there. When you do the conversion, your conversion amount would be $5,500, which is the same as your basis, so that gets calculated into a $0 taxable income and you’re set.
But if you already had an existing Traditional IRA that had, say $11,000 in it and you open a new one with a non-deductible $5,500 contribution, the IRS would treat it as one big IRA where 2/3’s of the account was deductible and 1/3 was non-deductible. So if you were to try to perform the IRA conversion. Only 1/3 of that ($1,833) would be non-taxable while the other 2/3’s ($3,667) would be added to your taxable income. That’s probably not what you wanted.
However, money in a 401(k) or similar employer plan would NOT be counted as part of the IRA attribution rules, so in the common scenario of having most of your retirement savings in a 401(k) and a Roth IRA outside, you could do this backdoor Roth IRA conversion without running afoul of the attribution rules.
If you have a combination of 401(k)’s, Traditional IRA’s, and a Roth IRA and want to make a backdoor Roth IRA contribution, you could theoretically still do it. Let’s say you wanted to make a $5,500 backdoor Roth IRA contribution and you had $100k in a 401(k) and $50k in a deductible Traditional IRA. You could consolidate the $50k Traditional IRA into your $100k 401(k) resulting in a 401(k) worth $150k. Then you open up a new Traditional IRA account and make a $5,500 non-deductible contribution. Then finally you convert THAT into the Roth IRA.
That may be a level of complication that may not be worth it though.
Remember, Backdoor Roth IRA contributions are only necessary if you make too much money to do a normal contribution. Unless, you know, you…like…going in through the back door…
Regardless, always consult a tax professional before you do anything to make sure everything’s done, filed, and documented properly. Laws change all the time, so double check!
So that’s how you do a Backdoor Roth IRA contribution. Has anyone ever done this? Was the process easy for you or were there headaches? Let us know in the comments!
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