Is the Backdoor Roth IRA strategy right for me?
Contributors: Allen Schaefer, CPA, MBA and Bernard M. Holand, CPA, PFS
New York, NY — February 28, 2022
Who does not love tax-free income? With several individual retirement account (IRA) options to choose from, how should you determine which one is right for you? With a Roth Individual Retirement Account (hereafter “Roth IRA” or “Roth”), a special individual retirement account funded with after-tax dollars, individuals can achieve tax-free income. While high-income earners cannot contribute directly to a Roth IRA due to there being an income cap, thanks to a tax loophole they may be able to contribute indirectly via a Backdoor Roth IRA, a type of conversion that allows people with high incomes to sidestep the Roth's income limits. In this article, we will examine the benefits and risks of a Backdoor Roth IRA strategy.
Here is what you need to know:
While Traditional IRAs and Roth IRAs provide attractive tax benefits to incentivize saving for retirement, those benefits are only available to individuals who earn up to a certain income threshold – For 2022, the income phase-out range for taxpayers making contributions to a Roth IRA is $129,000 to $144,000 for singles and heads of household (up from $125,000 to $140,000 in 2021). For married couples filing jointly, the income phase-out range is $204,000 to $214,000 (up from $198,000 to $208,000 in 2021). Those above the threshold cannot take advantage of a Roth IRA. For contribution purposes, you must first have eligible compensation to contribute to an IRA. Eligible compensation includes wages, salaries, tips, commissions, nontaxable combat pay, and income from self-employment.
Unlike with Traditional IRAs, which is a retirement account that allows individuals to make pre-tax contributions, the IRS does not require the original account holder of a Roth to take any required minimum distributions (RMDs) when they reach age 72. How much you can contribute depends on your modified adjusted gross income (MAGI). A full contribution for 2021 and 2022 is $6,000. And if you are 50 or older, you can contribute an additional $1,000.
Currently, there are no income limits on nondeductible IRAs or conversions from other qualified plans to a Roth IRA. Since these contributions are nondeductible and have already been taxed, you can convert the funds in those qualified plans to a Roth IRA tax-free. This strategy is commonly referred to as a Backdoor Roth IRA. A Backdoor Roth IRA conversion enables high-income earners to achieve tax benefits for which they would not otherwise be eligible.
In the event you have deductible contributions in a Traditional IRA then only a portion of the funds converted to a Roth IRA will be tax-free. When determining your tax bill on a conversion from a Traditional IRA to a Roth IRA, the IRS requires that you look at all of your Traditional IRA accounts combined and determine the tax based on a computed ratio. When paying the tax bill, it would be prudent to pay such from other assets that are earning taxable income as this would allow the Roth IRA funds to grow tax-free.
Spousal Eligibility Rule
Non-working spouses generally are not eligible to contribute to tax-advantaged retirement accounts, such as IRAs, because they do not have "eligible" compensation, as mentioned earlier, on which to base such contributions. There is an exception, however. If you are the working spouse and you want to make an IRA contribution for your non-working spouse, you must meet the following criteria: (1) you must have eligible compensation of at least the total spousal IRA contribution plus your own IRA contribution - to the extent applicable, and (2) file a joint federal income-tax return with your spouse.
Plan In Action:
First, make an after-tax contribution into a non-deductible Traditional IRA.
Second, transfer the funds from your non-deductible Traditional IRA to a Roth IRA account.
Third, contact your investment professional and coordinate the conversion process.
Fourth, let the funds grow, tax-free of course.
Is it Wise to Use the Backdoor Roth Now?
Congress is targeting the Backdoor Roth IRA strategy. Under the Biden Administration, the Build Back Better Bill, which the Senate failed to pass in late 2021, would in effect have eliminated the Backdoor Roth IRA loophole. While that bill has stalled for now, there is a possibility that another similar bill will resurface in the future and so it may make sense for you to consider doing the conversion before the backdoor, pun intended, closes. Due to recent stock market declines and if one believes markets will recover, this may be an opportune time to act.
Final Thoughts
If you did not make any IRA contributions for 2021 yet, do not fret. There is still time as the deadline for the 2021 contribution is April 15, 2022.
When considering a Backdoor Roth IRA, know that this is a complicated tax strategy and may require consulting with a Perelson Weiner tax professional.