backdoor Roth IRA and I should I have one?
There seems to be a cycle of financial terms du jour, one of the latest being backdoor Roth IRAs. It’s been bantered about,
especially targeted to those approaching retirement, yet many still don’t really know what it is.
A backdoor Roth IRA isn’t really a thing, rather a strategy to convert a traditional IRA into a Roth IRA for those whose income
maay be too high to contribute to a Roth IRA. It seems like it may be sneaky, especially given the name “backdoor” but it’s completely legal and an administrative procedure that’s been used for some time by those in the know.
Before we talk about how to do it, let’s talk about why you would want to do this? Roth IRA money is post tax which means you
pay taxes before contributing. The main benefit is that once that tax is paid, there’s no tax on withdrawals, including earnings, as long as you hold it for 5 years and wait until at least 59 ½ to withdraw.
Additional features that may make a Roth IRA
- There are no RMDs (Required
Minimum Distribution) at any age, as opposed to RMD at 70 ½ with traditional
- If you don’t need the money, leave
it to continue growing tax free until needed or for your heirs.
- Reduces possible tax burden during
- If you don’t need the money, leave
- Withdrawals of contributions are
allowed at any time without having to pay penalties or taxes.
- Heirs can spread withdrawals out
over many years and withdrawals are tax free, as opposed to traditional IRAs
where heirs must pay tax on distributions.
However, even with these benefits, deciding whether to Roth or not, is a personal decision. There are tax implications for
the year in which a conversion takes place and the taxes could be substantial. Additionally, if you anticipate earning significantly less during retirement than you currently make, the traditional IRA make be just the thing for you.
If you decide to convert, here’s how you go about it:
1. Open a Roth IRA if you don’t already have one.
2. Transfer funds from the traditional IRA to the Roth IRA. You can convert as much as you want but you may want to consider spreading the conversions across multiple years to spread out the tax burden and reduce the possibility of being bumped up to the next tax bracket.
a. The safest way to do this is directly from financial institution to financial institution to avoid withholding or risk of penalty.
i. If the IRAs are both at the same institution, contact them and request the transfer of funds.
ii. If they are at different institutions, you can direct the transfer from the institution where the Roth IRA is located. They will coordinate the transfer.
b. You can also opt to take an indirect rollover where the money is sent to you to deposit into your Roth IRA.
i. The institution holding the traditional IRA will withhold 20% for federal taxes.
ii. You will have 60 days to deposit the full balance, including the 20% amount withheld. If you miss the 60 day mark, you will owe an additional 10% penalty.
3. You’ll pay taxes on any contributions that were pre-tax or for which you took a tax deduction AND pay taxes on any earnings.
a. It’s highly recommended that you pay for the taxes out of pocket.
i. If you use an indirect rollover and use part of the proceeds to pay these taxes, the IRS will view it as a distribution and you will owe a 10% penalty on that money.
ii. There are pro-rata rules that are used to determine how much of your conversion amount will be taxed.
iii. These rules basically say that your conversion amount must include the same ratio of non-deductible funds that is in total of your traditional, SEP, and Simple IRAs.
iv. To calculate the taxable amount of your distribution:
- Add up all balances of all IRAs, including Simple IRAs and SEP. Do not include Roth IRA or non-IRA employer retirement plans.
- Add up all the post-tax dollars in all IRAs, including any post-tax employer retirement rollovers into IRAs.
- Divide the amount in #2 by the amount in #1 to determine the percentage of post-tax dollars in your IRAs. For example if you have $10,000 in post-tax dollars and your total IRA balance is $100,000, your percentage would be 10%.
- Multiply the percentage calculated in step 3 by the amount of your distribution which gives you the amount that is tax free. If you are converting $10,000, then $1,000 is tax free.
- Subtract the amount in #4 from your total distribution to determine the amount that is taxable. Using the same example, $9,000 is the amount that is taxable as ordinary income.
b. Taxes will be paid as part of your year-end return.
i. You’ll receive forms 1099 and 5498 that will reflect the distribution and conversion. Unfortunately, the 5498 form won’t be received until after April 15 since you have until then to contribute to IRAs.
Undertaking a Roth conversion could be a savvy long term move but the tax implications could be hefty. Be sure to evaluate it carefully and consult with your CPA before making a decision.