The Backdoor Roth IRA

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Earning too much money to contribute to a Roth IRA — and its unique tax benefits — is what most people would call a nice problem to have. Even better, it’s barely a problem anyway, since there’s a loophole that props open a back door to Roth IRAs for high earners.

Financial experts are big fans of Roth IRAs. That’s because you only pay taxes on contributions up front, and then you get to withdraw that money and its earnings in retirement without paying Uncle Sam another dime. If your tax rate is higher when you retire, that can put more money in your pocket versus a traditional IRA.

Unfortunately, not everyone qualifies to contribute to a Roth IRA because their income falls above certain limits, which we’ll cover below. But even if you make too much to qualify, there’s still a way to reap the benefits of a Roth. This technique, called a backdoor Roth IRA or a Roth IRA conversion, is available regardless of your income, tax filing status, or other retirement accounts you may already have.

Roth IRA Income Limits for 2016

First, make sure you truly make too much to contribute to a Roth IRA the regular way. These are the 2016 income limits, which vary based on your tax filing status:

  • Single: You can contribute the full amount ($5,500 per year, or $6,500 if you’re 50 or older) to a Roth IRA if your modified adjusted gross income (MAGI) is $116,000 or less. If your MAGI is $116,001-$131,000, you can contribute a reduced amount; if it exceeds $131,000, you cannot contribute to a Roth IRA.
  • Married filing jointly: You can contribute the full amount if you make $183,000 or less combined. If your MAGI is between $183,001 and $193,000, you can contribute a reduced amount; if your household’s MAGI exceeds $193,000, you cannot contribute to a Roth IRA.
  • Married filing separately: Your MAGI cannot be more than $10,000 to contribute to a Roth IRA. If your MAGI is less than $10,000, you can contribute a reduced amount. (In other words, you can never contribute the full amount to a Roth IRA if you’re married filing separately.) Note that if you did not live with your spouse during the year, you can use the limits for single filers.

What Is a Backdoor Roth IRA?

If your income exceeds the numbers above, congratulations: That’s a nice problem to have. Even better, if you have already have a traditional IRA or 401(k), you can still reap the benefits from a Roth IRA, too.

While there are strict income limits on yearly contributions to a Roth IRA, there are no longer such limits on rollovers. Changes made to tax laws in 2010 mean you can now roll over as much money as you want from your traditional IRA or 401(k) into a Roth, even if you make too much to contribute the usual way. This technique is called a backdoor Roth IRA, or sometimes a Roth IRA conversion.

Why might I want to use a backdoor Roth IRA?

If you’re saving for retirement with a traditional IRA or through a 401(k), you may wonder whether you really need to add a Roth IRA to the mix. Like all other financial decisions, whether a backdoor Roth IRA makes sense for you will depend on your own unique situation.

Roth IRAs differ from traditional IRAs in some important ways. Here are some major points to consider before you pull a trigger on a backdoor Roth IRA:

It could result in tax savings in the long run.

If you stand a good chance of retiring in a higher tax bracket, it makes sense to put some of your money in a Roth IRA. That’s because you’ll pay taxes on the contributions right now, while you’re in a lower tax bracket, and then take your withdrawals tax-free in retirement. Plus, you’ll be able to withdraw any earned interest or investment gains completely tax-free. That can mean quite a bit of savings in the long run.

If you’ll be retiring in a lower tax bracket, however, you might save money by delaying the tax bill until you retire, which you can only do with a traditional IRA or a 401(k).

For an example of the potential tax savings, let’s say you’re 35 now and have an adjusted gross income (AGI) of $65,000, which puts you in the 25% tax bracket. (Note that this income would make you eligible to contribute to a Roth IRA anyway, but this example is simply to illustrate the type of impact taxes can have on your account.) You expect to at least double your income by retirement, putting you in the 28% tax bracket at that point. If you put $3,000 in your IRA every year and assume a 7% return, a Roth would leave you with more than $303,000 after taxes, while a traditional IRA would be worth about $30,000 less due to the later tax hit and paying taxes on the investment gains.

You could let your money keep growing — for you or your heirs.

Maybe you have ample retirement savings and don’t need to tap all of it. If your money is in a traditional IRA or 401(k), the IRS will force you to start taking required minimum distributions from those accounts starting at age 70½.

You also can’t contribute to a traditional IRA past that age. However, that’s not the case with a Roth IRA, which allows you to keep making contributions and growing your money. That can mean a lot more cash in your account.

For example, let’s say you’re 70 and have $300,000 in your Roth IRA. You want to continue to make contributions and refrain from making any withdrawals for another decade. Contributing the maximum ($6,500) each year for another 10 years — and assuming growth of roughly 7% — will more than double your money to $686,000. Even if you just let your money grow and don’t make any more contributions, you’ll have more than $590,000 by age 80.

If you can keep your hands out of your Roth IRA indefinitely, your heirs can access the money tax-free, too. They will have to start taking distributions, but under current rules they can stretch them out based on their life expectancy. That means much of the money can keep growing for them, too.

Paying Taxes on Your Backdoor Roth IRA

The main downside of using a backdoor Roth IRA is that you’ll have to pay taxes on the money you convert now — both on the contributions and any earnings you’re rolling over from your original account. (This assumes that you’re rolling over tax-deductible contributions, as is the case for most people. If you will be including nondeductible contributions, your tax bill will be based on the ratio of deductible and nondeductible contributions.)

Again, in the long run, it’s better to pay the taxes now if you expect to retire in a higher tax bracket (or if you believe, as some do, that tax rates in general will go up by the time you retire). However, this can be a big con if you don’t have the money for the tax bill.

In general, you’ll want to use money from savings or a source other than your retirement account to pay those taxes. Otherwise, you could drastically cut into future earnings just to pay your tax bill, and on top of that owe a penalty for early withdrawals if you’re younger than 59½.

One way you can soften the tax blow is by stretching out your conversion. Take this simplified example: Perhaps you have $40,000 that you want to convert to a Roth IRA. If you’re already making $180,000 a year, withdrawing that $40,000 to convert it into a Roth will bump you up to an AGI of $220,000 — and from the 28% tax bracket up to the 33% bracket. Your tax bill would jump about $13,000 as a result, from $40,700 to $53,300. Alternatively, you could convert $8,000 a year for five years, keeping you in the same tax bracket and raising your tax bill a more manageable $2,200 each year.

How to do a backdoor Roth IRA

How you convert your money to a Roth IRA partially depends on where you had it before. Most popular brokerages, such as Scottrade and E*TRADE, can walk you through the rollover, as can online financial advisors like Betterment and Wealthfront. Here are your options:

  • Same-trustee transfer: If your money is staying with the financial institution where it’s already managed, simply set up a Roth with the firm and ask for the money to be transferred. You may also be able to change the account type without an actual transfer. Either way, you’ll never actually see the money, and you may even be able to accomplish the task online.
  • Trustee-to-trustee transfer: If you’re setting up a Roth IRA with a financial institution other than the one that manages your current account, simply tell your current account manager to direct the money to the new trustee of your Roth. You won’t see the money with this kind of transfer, either.
  • 60-day rollover: A 60-day rollover lets you plunk the money that you’re transferring in your own bank account first. You’ll have 60 days to deposit it into your new Roth IRA. But beware: If you don’t make that deadline, you’ll face a 10% early withdrawal penalty (if you’re younger than 59½) in addition to income tax on whatever amount you’re converting. Financial advisors typically warn against the 60-day rollover since the consequences for missing that window are so steep.

Consider These Red Flags Before Converting to a Roth

Does a backdoor Roth IRA sound like a great opportunity? It can be — but converting is also a complex topic that demands a careful analysis of your unique situation. We recommend consulting a financial advisor before deciding one way or another, but in the meantime, here is a summary of the major red flags that should slow down your rush to convert to a Roth:

  • Red Flag No. 1: You’ll retire in a lower tax bracket. If you’re like most people, your income — and tax rate — will fall when you hit retirement, so converting to a Roth IRA could actually cost you money. That’s because you’ll pay taxes on your contributions now, while your tax rate is higher, instead of paying the tax bill when you retire, as you would with a traditional IRA.
  • Red Flag No. 2: You’re retiring soon and need the money to live off of. Financial experts recommend you give yourself at least 15 to 20 years for the Roth IRA to grow enough to earn back what you lost in taxes and then some.
  • Red Flag No. 3: You can’t afford the taxes from sources other than your retirement accounts. Don’t rob yourself of future earnings on that money — especially if raiding your account will mean an early-withdrawal penalty.

Want to learn more? The Simple Dollar offers lots of guidance for anyone who wants to save smartly for retirement. Check out these other popular posts for more tips and advice: