Backdoor Roth IRA

A Backdoor  is simply an indirect technique to make a contribution to a Roth IRA in the event that you are non-eligible for a direct contribution due to your high income.

There are no restrictions on income when you are contributing to a non-deductible traditional IRA. Limits are also not imposed when converting a traditional IRA to a Roth IRA.

Backdoor Roth IRA

In case your income is deemed “too high” for contributing to a Roth IRA, consider a Backdoor Roth IRA. The phaseout of the modified adjusted growth income (AGI) in 2015 begins at $116,000 and $183,000 for single and married filing jointly respectively. For married filing separately, it is $0.

In case your income exceeds the above thresholds, you cannot take advantage of a Backdoor Roth. Instead, consider a deductible contribution to a traditional IRA. The latter is possible only if you are eligible for one or you can directly contribute to a Roth IRA.

Rationale for adopting the Backdoor IRA path

If you have money stashed away in taxable accounts, there is a requirement to pay the applicable on dividends and interest. When the assets are eventually sold, there is also the need to pay taxes imposed on capital gains. You do not have to pay such taxes if you put your money into a Backdoor Roth IRA.

Empirical view

When you contribute to a Backdoor Roth IRA, you are simply making a nondeductible contribution to a traditional IRA prior to making a Roth conversion. The pre-existing IRA funds (non-Roth), however, in the traditional, SIMPLE and SEP will in all possibility be the pre-tax earnings and their deductible contributions. In case you are making a Roth conversion, it will not be possible for you to limit the conversion to just the nondeductible contribution.

When you file your income taxes, any money converted by you will represent all money present in traditional, SIMPLE IRA and SEP accounts, independent of the account Roth conversion money is sourced from.

To give an example: if the nondeductible contributions made by you comes to only 25 percent of the total money stashed in your SEP, SIMPLE SIRA and traditional accounts, then the tax free amount will be limited to 25 percent of the Roth conversion amount. For the remaining 75 percent, the Roth conversion sum will represent pre-tax or deductible money across all the traditional, SIMPLE and SEP IRAs.

As a result, the tax owed by you (at the present rate of income tax) will come to 75 percent of the Roth conversion amount. If it is possible for you to transfer to a employer sponsored 401(k), solo 401(k) or the 403b, then there will be no taxation imposed on them during the Roth conversion process.

Cautionary terms

In case you possess any other IRAs, you should know that the taxable part of any conversion made by you is then prorated over all the IRAs. It will not be possible for you to exclusively convert the non-deductible amount. If you wish to benefit from Backdoor Roth IRAs, there is a need to convert any other IRA(s) you hold as well.

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