A Roth backdoor entry is a bypass to get around income limits to participate in Roth IRA. The other key aspect of this backdoor is that there are no conversion limits so you can convert any amount as long as it is in your IRA.
Is it Legal? In one word, Yes. There are a few complications though so I am describing them in this article.
What is Roth IRA
Roth IRAs are a unique and powerful way to save for retirement. You pay taxes up front on a Roth IRA, but after that, all growth and withdrawals are tax-free in a Roth IRA. There are some limits to investing in Roth IRA though.
- Income Limit – If you earn more than 133,000 (Single) or 196,000 (Married filing jointly), you cannot invest in Roth IRA. The contribution amounts start reducing at 118,000 (single) and 186,000 (Married). For latest limits, please check Roth IRA Limits
- Contribution Limits – You may contribute only $5,500 ($6,500 if you are over 50) to a Roth IRA.
What is Backdoor Roth
Backdoor Roth is a scenario where you convert a traditional IRA to a Roth IRA. Currently, anyone can do this irrespective of how much income you person may have. You can also roll as much money as you want (or have) to a traditional IRA. This is not a tax evading technique as you would have to pay taxes on any income in Traditional IRA that is not yet taxed but it allows someone who makes more than Roth IRA limits to still invest in Roth IRA.
E.g. If you make $ 200,000 a year and are not eligible to invest in Roth IRA. You can open a Traditional IRA, and not take any tax deduction on it (non-deductible). Then, you can immediately convert it to a Roth IRA. Since you didn’t claim any deduction on the individual IRA, there is no tax to be paid and you are able to invest in Roth IRA even though you make more than the eligible investment limit of Roth.
Are there no taxes at all? What is the catch?
There is a key caveat here. IRS treats your all your IRA accounts as same. If you have an IRA account with Scottrade and another one with Fidelity, IRS treats them as one. It is not just for traditional IRA but also for SEP and Simple IRA. That means, if you already have an IRA account, you cannot open a new one, convert it to Roth and avoid paying any taxes. In this scenario, your contribution to Roth is considered as a pro-rata contribution from your total IRA and depending on if your traditional IRA was deductible or non-deductible (you paid taxes on it or not), you may owe taxes to IRS. You need to go through the Pro-Rata rule in detail before going down this route. You can avoid Pro-Rata rule if you are able to roll over rest of the money to a 401K plan before the end of the year.
Is Roth IRA beneficial over Traditional IRA?
Roth IRA has several key benefits. Considering that we are at the lowest tax rates historically and are reducing it further in short-term, it may be a very good opportunity to convert as much traditional IRA investments to Roth IRA and grow these investments tax-free. Also, there will be no tax on withdrawals post 59 1/2.
There are several added benefits of Roth IRA like there is no Required Minimum Distribution post 70 years, you can easily pass this to your children without tax implications and it can be used to avoid estate tax as well (though Trump may remove estate tax itself). Still, if you are in lower tax brackets, Roth IRA definitely has more value than higher tax brackets.
Is backdoor Roth for me?
If you are above the income limits of Roth IRA, this is, for now, the only option to invest in Roth IRA. There is one more scenario where backdoor Roth IRA is beneficial even if you are eligible to invest in Roth IRA due to income limits.
The scenario is that you have moved out of a job and have rolled over your 401K into a traditional IRA (or has a traditional IRA from old investments) and the amount of investment in the traditional IRA is not too high that it would bump you to the next tax bracket, you can use backdoor Roth to convert all of you IRA into Roth and pay taxes on the conversion.
If there is any year where your income is low or negligible (you are without work for some time or may have moved out of US ), you can use the opportunity to convert your old IRA into Roth IRA in its entirety, pay taxes that you need to pay and convert all of your pre-tax investments to post-tax. With Donald Trump is talking about making taxes an all-time historic low, it is actually a good time to roll over previous job 401Ks into IRA and then Roth. This works even better if you are in a low tax state.
Is backdoor Roth permanent?
With the new government, IRA, Roth and other investments are subject to change. There is a possibility that this backdoor will get closed at some time in future. Roth was initially created to allow lower earning citizens and younger savers to save while utilizing lower incomes and lower tax rates. It was later expanded to higher income individuals to bring the investment amount and income limits to the current level.
To conform to that ideology, there is a possibility that this backdoor is closed. If you want to take benefit of this opportunity, you have to do it before this gets closed.