The Backdoor Roth IRA: Personal Finance's Sneakiest Maneuver

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By Roger Ma

NEW YORK -- A Roth IRA is the ultimate retirement vehicle, as it allows you to contribute post-tax dollars to a retirement account. That means a Roth IRA grows tax-free and is withdrawn tax-free since you've paid taxes on the money upfront. Essentially, consumers pay taxes on the seeds they sow instead of the robust crop they harvest in retirement. That's just peachy -- until you bump up against income barriers. If you make too much money, you might find yourself blocked from contributing to a Roth IRA -- that is, unless you go through the backdoor.

Slipping Into a Roth IRA

For 2015, only individuals making less than $131,000 a year or a married couple making less than $193,000 a year can contribute directly to a Roth IRA. Thus, higher income earners are effectively locked out from contributing directly to a Roth IRA.

However, in 2010, income restrictions were removed from Roth conversions, which opened the "back door" to allow anyone to contribute to a Roth IRA, either directly or indirectly.

If you exceed the Roth IRA income limits, you can perform the below steps to contribute to a Roth IRA:
  1. Open a traditional IRA, if you don't have one already.
  2. Make a nondeductible contribution to your traditional IRA, up to the limit of $5,500 a year for those under 50 and $6,500 a year for those 50 and over.
  3. Shortly thereafter, convert your nondeductible contribution from your traditional IRA to your Roth IRA.
Upon your conversion, you'll only owe taxes on the growth of your nondeductible investment from the time when you initially made your contribution to your traditional IRA to when you ultimately converted it to your Roth IRA. Since this is typically a very short amount of time, your tax liability from the conversion should be minimal.

Matthew Heaney, a 51-year-old software engineer based in San Jose, has been utilizing the backdoor Roth IRA strategy since he heard about it five years ago. "Because the money grows and is withdrawn tax-free, what you see is what you get," he said. "During retirement, I'll be able to make withdrawals from my Roth IRA without having to worry about paying taxes or how those withdrawals will affect my taxable income."

Financial advisers also swear by the Roth. Jeff Jones, a Certified Financial Planner with Cypress Financial Planning in Woodbury, New Jersey, leans on Roth IRAs extensively in his practice. "After ensuring company 401(k) matches are being maximized and high interest debt is eliminated, I make sure every client utilizes a Roth IRA to the fullest extent," he told TheStreet.

Pre-tax 401(k)s and traditional IRAs, on the other hand, allow you to invest pre-tax monies into a retirement account that grows tax-free. When you begin taking withdrawals from these accounts, you'll be taxed on the entire amount of your withdrawal (contribution and growth) at your ordinary income level.

This additional tax diversification could be a very valuable benefit, especially if you're able to isolate tax-inefficient investments, such as REITs, into your Roth IRA. That could help those planning for retirement save a bundle in taxes.

While there is some fear that the government could eventually shut down the backdoor Roth IRA -- trying to put the kibosh on a tax break that seems too beneficial to citizens -- it's a skilled trick retirement savers can safely use to their advantage. As an added bonus, unlike traditional IRAs, Roth IRAs don't have the required minimum distribution that takes effect an an account holder nears age 71. That means, a Roth IRA account holder has the flexibility to let his money grow or take it out for use as needed.

Beware of the Pro-Rata Rule

The backdoor Roth IRA strategy works best when you don't have any outstanding traditional, SEP or simple IRAs. If you do have any of these accounts, you should consider rolling the monies into your current 401(k) plan. If that's not an option, you should think twice before doing the backdoor Roth IRA strategy.

The reason the strategy becomes a little hairy when you have existing IRAs outstanding is the IRS forces you to convert monies on a pro-rata basis rather than allowing you to select specific monies to convert.

For example, let's say you have $15,000 in deductible contributions in a traditional IRA. You make a nondeductible contribution of $5,000 into your traditional IRA with the goal of converting it into a Roth IRA. Not so fast. Unfortunately, because of the pro-rata rule, in this situation, if you converted $5,000 into a Roth IRA, you would owe taxes on $3,750 of the $5,000 (at your ordinary income level). This is because 75 percent of your IRA is made up of deductible contributions ($15,000 / $20,000 = 75 percent) while 25 percent is nondeductible contributions ($5,000 / $20,000 = 25 percent). When you make the conversion, the IRS assumes the monies are converted on a "pro-rata basis." As a result, 75 percent of the $5,000 you converted is assumed to be made up of deductible contributions, and thus, taxable.

When employing the backdoor Roth IRA strategy with clients, Jones of Cypress Financial Planning takes care to heed these necessary caveats. "I first take steps to ensure there are no outstanding pre-tax IRA funds due to the pro-rata rule," he said. "Then, each spring, I work with clients to max out their Roth IRA with no adverse tax consequence."

Bottom Line

The backdoor Roth IRA strategy is a great tool to allow high-income earners to contribute up to $5,500 a year ($6,500 for those 50 and over) to a Roth IRA. With that said, the strategy works best if you don't have any traditional, SEP or simple IRAs outstanding. Before proceeding with the strategy, make sure to roll over any IRAs to an existing 401(k) to make the conversion as clean as possible and to ensure minimal tax liability.
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