An Effective Step Toward Tax Diversification
Tax diversification is a planning concept that we stress in our books, and in our work with clients. This concept can be especially important for year-end planning, when most know what their tax situations are for the year. Tax diversification can also be an important goal to revisit in January as you consider planning strategies to implement for the coming year.
Essentially, tax diversification means building assets in a variety of “buckets”, each of which will be taxed differently when liquidating for retirement. One such “bucket”, which is often under-utilized, is the “tax-free” bucket – assets that will come to the client tax-free in retirement. Roth IRAs can play an important role in this asset group but may seem to be off limits for many higher-income earners, because of strict income caps on contributions to these accounts. However, even if your income disqualifies you from being able to contribute to a Roth IRA, the backdoor Roth IRA strategy can provide a way for you to take advantage of these accounts – and help you achieve better long-term tax diversification.
The appeal and limitations of a Roth
With a Roth IRA, you get no up-front tax deduction, as you do with a traditional IRA, 401(k) retirement plan or other tax-deferred account. However:
- You pay no tax on either principal or earnings when you withdraw your money (although you must be at least age 59½ and have had the Roth for five years).
- There is no required minimum distribution, or age when you must withdraw money—an appealing option for those who want to leave the money to heirs.
The trouble has been, of course, that Roth IRAs technically are only available to those whose annual income is below certain levels. In 2021 those limits are:
- $207,999 or less for married couples filing jointly
- $139,999 or less for single filers
A backdoor Roth IRA circumvents those income restrictions. The recent tax reform legislation confirms that backdoor Roth IRAs are an allowable transaction. Taxpayers who had shied away from using backdoor IRAs for fear of running afoul of the IRS now have a clear path to using this strategy to create Roth IRAs.
How it Works
So how does a backdoor Roth IRA work? Instead of contributing to a Roth IRA directly—which you may not be eligible to do because of the income restrictions — you make a nondeductible contribution to a traditional IRA. No income restrictions apply to your right to put money into a traditional IRA.
Nondeductible means you are using money left over after you pay your income taxes. The tax impact is a wash because you would not have been allowed to deduct a direct contribution to a Roth IRA anyway. Both are so-called after-tax contributions.
After putting the money into a traditional IRA, you convert or transfer it to a Roth IRA. You can contribute up to $6,000 a year to a traditional IRA, or up to $7,000 if you are age 50 or older, and you can convert the money at any time.
Still, remember to follow certain rules:
- You must have earned income. Otherwise, you are not eligible to make a nondeductible contribution to a traditional IRA. But there is a helpful exception to that rule: For married couples filing a joint return, the backdoor Roth IRA can be doubled by having a nonworking spouse also contribute to his or her own IRA. The working spouse must have enough earned income to cover the contribution for the nonworking spouse.
- You cannot convert money to a backdoor Roth IRA if you are over 72 years of age. If a worker is contributing for a nonworking spouse, the nonworking spouse also must be younger than 72.
- Obey the IRS’s pro-rata rule in calculating tax on the conversion amount. The pro-rata rule is a rule that dictates the taxation of an IRA distribution when the IRA owner has any IRA containing after-tax amounts. The rule states that, in general, an IRA distribution will consist of the same proportion of pre-tax and after-tax amounts as the IRA owner has in his or her IRA(s). Furthermore, for the purposes of this rule, all of a taxpayer’s traditional IRAs – including SEP and SIMPLE IRAs – are looked at as a single IRA.
The crux of the calculation is this: You pay taxes in proportion to the original account’s pretax contributions and earnings. Suppose you kick in $6,500 to a nondeductible traditional IRA. In addition, you also have an IRA worth $93,500, funded entirely with deductible contributions. As a result, 93.5 percent of any conversion would be taxable.
If you have no other IRAs, the calculation is simple. Better yet, the conversion will be tax-free because the amount converted will consist only of after-tax, nondeductible money.
- The IRS recently confirmed this strategy is an allowable transaction.
- By using this strategy, you work around the income limits.
- How it works – Contributions
- You contribute to a non-deductible traditional IRA.
- You then convert that contribution to a Roth IRA.
- How it works – Conversions
- If you have an IRA balance you can convert that account (or partial account) to a Roth IRA.
- The amount converted is taxable (or partially taxable) and included in your income.
A Backdoor Roth IRA can be an effective strategy towards building assets for retirement and achieving tax diversification in your overall portfolio. A professional financial advisor can help you understand the related IRS rules and successfully implement this strategy. The authors welcome your questions.