What Is a Backdoor IRA?

I could take a poll, but I suspect I know the answer: No one wants to pay more at tax time. But many retirees do -- especially high-income earners who didn't take advantage of a backdoor Roth IRA during their career.

To be clear, there's no such thing as an official backdoor Roth IRA. If you go to your investment firm's website and search for an application for a backdoor Roth IRA account, you'll come up empty-handed. Instead, a backdoor Roth IRA is the nickname for a strategy that allows you to sidestep income restrictions that prevent you from contributing to a good old-fashioned Roth IRA. It's an increasingly common strategy, because it's pretty simple to execute and delivers a lot of tax-savings bang for the buck.

Here's what you need to know about backdoor Roth IRAs, including tips for executing this strategy flawlessly.

What exactly is a backdoor Roth IRA?

If you're a high-income earner, the IRS prevents you from directly contributing to a Roth IRA. That's a bummer because Roth IRAs are a great wealth-building tool. They allow any after-tax money you contribute to grow tax-free. And in retirement, money can be withdrawn tax-free if you're 59 1/2 or older and a Roth account has been open in your name for at least five years.

Although high-income earners can't directly contribute after-tax money to a Roth IRA, they can fund a Roth IRA through the backdoor approach. Since traditional IRAs don't have an income limit for contributions and traditional IRAs can be converted into Roth IRAs, individuals can fund a traditional IRA with nondeductible contributions, and then convert the account into a Roth IRA. This maneuver -- commonly called the backdoor Roth IRA -- allows high-income earners to get the same Roth IRA benefits as everyone else.

Is a backdoor Roth IRA right for me?

The backdoor IRA isn't for everyone. In fact, if you file your income taxes jointly, and your household income isn't above $193,000 in 2019, there's no reason for you to read any further. A regular Roth IRA will work perfectly fine for you.

Why? Because the IRS only prevents you from contributing fully to a Roth IRA if your income exceeds an annual limit. As long as your income is below the cap every year, you can invest directly through a Roth IRA without having to do the fancy tap-dancing necessary to execute the backdoor Roth IRA strategy.

Deductible or nondeductible IRA?

If your income is above the threshold, then the first thing you should understand is how Roth IRAs differ from traditional IRAs -- including simplified employee pension (SEP) IRAs and savings incentive match plan for employees IRAs (or SIMPLE IRAs).

Traditional IRAs and Roth IRAs both offer tax advantages. However, traditional IRAs offer up-front tax savings when you make your contributions, while Roth IRAs offer tax savings when you withdraw money later in life.

As long as you and your spouse aren't covered by a workplace retirement plan, such as a 401(k), any contributions you make to a traditional IRA can be deducted from your annual income in the tax year you make your contribution, thereby reducing your taxable income, and thus the amount you pay at tax time.

However, the tax deduction associated with contributing money to a traditional IRA is limited by income restrictions.

If you're covered by a workplace plan and you're single, then you can only deduct the full annual contribution to a traditional IRA if your modified adjusted gross income (MAGI) is below $74,000 in 2019. If your income is between $64,000 to $74,000, you'll only get a partial deduction. If you're married, the deduction begins phasing out when MAGI exceeds $103,000, and it disappears entirely above $123,000.

If your spouse is covered by a workplace plan, then the deductibility of traditional IRA contributions starts disappearing at $193,000, and it's gone entirely above $203,000.

The tax-deductible contributions you make to a traditional IRA will grow tax-deferred, but you'll have to pay income tax on any money (contributions and gains) that you withdraw in retirement. The IRS allows you to start taking money out of traditional IRAs at age 59 1/2, and it forces you to begin IRA withdrawals at age 70 1/2 if you haven't taken any money out of them yet. When you withdraw money from traditional IRAs, the tax you pay on that money is calculated at the prevailing income tax rate.

Alternatively, there's no tax deduction associated with Roth IRA contributions, so you'll owe income taxes on any money you contribute up front. However, unlike a traditional IRA, you won't pay a dime in income taxes when you withdraw money from your Roth IRA, as long as those withdrawals occur after age 59 1/2 and the account has been open at least five years. There's no mandatory requirement to withdraw money from a Roth IRA, either. So Roth IRAs can be a great way to pass on money to heirs.

The tax-free growth, tax-free retirement income, and legacy planning advantages associated with Roth IRAs make them compelling, but there's a hitch. In order to fully contribute to a Roth IRA, your income must be below a limit that changes every year. The following table shows you the Roth IRA income restrictions for 2019.

At first blush, this income cap suggests high-income earners can't enjoy a Roth IRA's benefits, but that's not the case. As I already mentioned, contributing to a traditional IRA and then converting it to a Roth IRA allows you to circumvent this income restriction.

OK, how do I open a backdoor Roth IRA?

There are some situations where executing the backdoor Roth IRA gets a bit complicated (we'll get to those in a minute), but for many, it's pretty straightforward.

First, you open a traditional IRA at a broker and make your nondeductible contribution. Remember, nondeductible contributions mean you will pay income taxes on the amount you're contributing. When you do your income tax return, make sure you don't deduct this contribution, or you'll run afoul of the IRS rules associated with this strategy.

Once you've funded your traditional IRA with your nondeductible contribution, you'll instruct your broker to convert it to a Roth IRA, or open a Roth IRA and fund it with money from your traditional IRA. Don't worry: This is a pretty seamless process that your brokerage or investment firm can help you navigate.

Boom! You're done. Instant Roth IRA goodness, regardless of how much you earn.

Is there a catch to a backdoor Roth IRA?

Sort of.

If you decide later you'd rather have the up-front deduction instead of the tax-free retirement income, you're out of luck. There are no do-overs, because the government has gotten rid of rules allowing you to recharacterize, or reverse, your Roth IRA conversion.

Also, the backdoor Roth IRA strategy gets complex if you have a lot of money in traditional IRAs already -- including SIMPLE IRAs or SEP-IRAs -- because of tax-deductible, rather than nondeductible, contributions in the past.

The IRS makes you pay income taxes on any money you convert from a traditional IRA to a Roth IRA. If your traditional IRA only included nondeductible contributions, then immediately transferring money from it to a Roth IRA won't incur any additional federal income tax. However, if you have tax-deductible contributions in the IRA, too, then you'll have to do some math, and perhaps get a little creative.

There are two rules that come into play here: the pro-rata rule and the aggregation rule. The pro-rata rule forces you to calculate the percentage of the amount you're converting relative to all the money in your tax-deferred IRA when determining your tax burden. The aggregation rule means that money held in multiple traditional IRAs must be added together as if it were in one account for this calculation.

For example, let's say you have traditional IRA with $35,000 in it and a SEP-IRA with $19,000 in it, and that all of your contributions to those accounts were deductible. Now, let's assume you want to do a backdoor Roth IRA this year. So, you open up another traditional IRA and fund it with the maximum annual contribution allowed, which is $6,000 in 2019. Then, you open a Roth IRA and choose to fund it with the $6,000 nondeductible contribution you made to the traditional IRA. So far, so good -- but there's a fly in the ointment.

You might think you can simply move the $6,000 to the Roth IRA without any additional tax. Unfortunately, that's impossible. The aggregation rule means you have to divide the amount your transferring by the total across all your tax-deferred accounts to determine how much of your conversion is considered taxable income.

In this scenario, dividing $6,000 by $60,000 -- the sum of all your accounts ($35,000 plus $19,000 plus $6,000) -- works out to 10%. So, only $600 of the $6,000 will be considered nondeductible, and thus not subject to income taxes. You'll end up owing income tax on the remaining $5,400 of the conversion. Ouch!

Is there a solution to the backdoor Roth IRA pro-rata problem?

A backdoor Roth IRA is simplest for those who are new to saving for retirement or those with retirement savings in workplace plans only, because workplace retirement plans, including 401(k) plans, aren't subject to the aggregation rule. However, there is an option available to those with existing traditional IRAs funded with tax-deductible contributions who also want to take advantage of a backdoor Roth IRA: a rollover.

If your employer offers a workplace retirement plan, such as a 401(k) plan, that allows direct rollovers from existing accounts, you could directly roll over your tax-deferred IRAs into it. Since employer sponsored plans aren't subject to the aggregation rule, rolling your old IRAs into your workplace plan avoids the pro-rata calculation, freeing you up to take advantage of a backdoor Roth IRA.

That's great, but what if your employer's plan doesn't accept direct rollovers?

In that case, it might be a great time to consider a side hustle so that you can establish your own individual or solo 401(k) plan. Of course, you'll need to generate at least a little self-employment income every year, and you'll need to make sure the solo 401(k) you set up does accept direct rollovers from existing traditional IRAs, otherwise all would be for naught.

This strategy is a little complicated, so consult with your accountant first to make sure you do everything correctly. As an example, here's how this strategy can be put into place:

• Start a business and go online to establish a tax ID number for it.
• Open a solo 401(k) with an investment firm that allows direct rollovers from existing traditional IRAs.
• Roll over your existing tax-deferred IRAs into your new solo 401(k) plan.
• Open a traditional IRA account.
• Fund your new traditional IRA account with this year's nondeductible contribution.
• Open a Roth IRA account or access your existing Roth IRA.
• Directly fund your Roth IRA account from the newly funded traditional IRA.

How to avoid backdoor Roth IRA pitfalls

If you plan to take advantage of a backdoor Roth IRA every year, then you might want to consider doing it early in the year and making your transactions in quick succession. You may also want to ask your investment firm or broker to keep your traditional IRA open after the transfer to avoid having to open a new traditional IRA every year.

If a lot of time goes by between when you fund your traditional IRA and when you use it to fund your Roth IRA, then you could wind up with taxable gains on your traditional IRA contribution that you need to deal with. For this reason, it may also be smart to invest your nondeductible traditional IRA contribution in a savings account that doesn't pay interest, or a money market fund that pays low interest. Furthermore, converting your contribution to a Roth IRA the day after your traditional IRA contribution may also minimize the likelihood of interest or gains to deal with.

It's also important to make sure you take the time to correctly complete IRS form 8606 every year. This form is used by the government to track your nondeductible contributions and calculate taxable and nontaxable distributions from IRAs.

Why bother with a backdoor Roth IRA?

Tax-free income from a backdoor Roth IRA is especially appealing when you consider that Roth IRA distributions in retirement don't count against you when determining if your Social Security income is subject to income taxes.

The IRS determines how much of your Social Security is taxable based on something it calls "provisional" income. If your provisional income in retirement exceeds annual limits that change every year, then up to 85% of your Social Security check could be subject to federal income tax. To calculate your provisional income, you include distributions from tax-deferred retirement accounts, such as IRAs or 401(k)s, as well as a variety of other line items, but you don't include Roth IRA distributions. Therefore, a backdoor Roth IRA can be a valuable tax-planning strategy, allowing you to keep more of your Social Security income out of Uncle Sam's pocket.

Also, unlike traditional IRAs, Roth IRAs aren't subject to required minimum distributions at 70 1/2. So you can leave them untouched, then pass them along to your heirs. The ability to leave money in a Roth IRA longer than in a traditional IRA means you have more time to benefit from compound growth -- or the ability to earn interest on your interest -- which may increase the size of your estate significantly.

Furthermore, when you pass it on to your heirs, you can stretch out tax-free Roth IRA withdrawals over their lifetime. This stretch-IRA advantage gives compounding even more time to work its magic, potentially providing income over a much longer period than if the money were inherited in a taxable account or traditional IRA.

Clearly, Roth IRAs offer benefits that shouldn't be ignored. Fortunately, the backdoor Roth IRA strategy allows you to take advantage of them. So far, Washington hasn't passed any laws preventing you from using this approach, but that may not be the case forever. Therefore, make sure you consult with your tax attorney first, especially if your situation is complicated. Since a backdoor Roth IRA strategy gives you more financial flexibility in retirement, regardless of your income, it's certainly worth considering.

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