What is a backdoor Roth IRA?

In late 2017, Congress passed the Tax Cuts and Jobs Act, changing several  features  of the tax code.

The standard deduction increased to $12,000 for individuals and $24,000 for married couples filing jointly for seniors.  For high income earners, the new tax law allows a backdoor approach that enables seniors  to fund a Roth IRA.

Andrew Crowell, Vice Chairman, Wealth Management, D.A. Davidson & Co. discussed with Fox Business  backdoor Roth IRAs, how investors can use them and why they are beneficial.

Boomer:  What is a backdoor Roth IRA?  Is this investment right for all investors?

Crowell:  Pre-planning during one’s accumulation years is a key part of maximizing and stretching an investor’s retirement accounts. Decades of diligent saving during one’s working years may now be followed by decades of retirement living, thanks to advances in modern medicine. This means that those hard-earned dollars will likely need to stretch further than in past generations. Naturally, choosing which annual contribution path (traditional versus Roth) is critical. Saving early and often in a Roth account—should that prove to be the optimal strategy for the saver based upon their needs, income level, taxes, etc.—is important to growing a substantial Roth balance. However, there are both income and contribution limits to these accounts which preclude many from taking advantage of this valuable benefit. For tax year 2018, couples who are married and filing jointly are unable to contribute to a Roth if they make $199,000 or more. So does that mean this account option is completely closed for higher net worth families?   Surprisingly, no. 

While the newly passed Tax Cut and Jobs Act of 2017 did not remove the adjusted gross income qualification limits for Roth contributions, it did continue to allow a valuable “Back Door” Roth opportunity for higher income families by expressly allowing the conversion of traditional IRA assets. This means that higher income families still have the ability to store away nuts for winter in a Roth. It’s important to note that any conversion of retirement assets should be thoroughly evaluated with an accountant or tax expert since the conversion of pre-tax traditional contributions to post-tax Roth contributions will create taxable income in the year in which they are done. However, investors can work with an advisor to strategically plan out how to spread the tax burden over multiple years by converting in stages, and if income fluctuates widely from year to year, they can take advantage of lower income years for potentially larger conversions, as they may be in a lower than normal tax bracket. While the backdoor Roth is not a new strategy, it was expressly preserved in the 2017 tax law when many had expected the backdoor to be slammed shut. 

Boomer:  What factors should be considered when contemplating a backdoor Roth IRA?

Crowell:  Consultation with a tax expert is advised when evaluating retirement account options like a backdoor Roth IRA. For example, because conversion of pre-tax contributions in a traditional IRA will become taxable during the tax year in which they are converted to a Roth, investors should consider whether they wish to convert some, part or all of the IRA balances. If the investor is still working and earns uneven income from one year to the next, they can potentially take advantage of the “lean” years to convert a higher balance to Roth since they may be in a lower tax bracket. Further, the investor can “spread” the tax burden across years by converting in stages rather than all at once.

Boomer:  What rules and restrictions apply for investors looking to leverage backdoor Roth IRA’s?

Crowell:  There are a host of rules surrounding both contributions and withdrawals from Traditional and Roth IRAs. For that reason, investors should consult with a tax expert in advance. In thinking specifically about the backdoor Roth IRA option, the most significant restriction which investors should know about is “The Five-Year Rule” for Roth IRA withdrawals. In short, an investor must have owned their Roth IRA for five years in order to withdraw earnings tax free during retirement. This rule applies not just to Roth contributions but to Roth conversions as well; this five year “clock” starts from the tax year of the conversion.