Back Door Roth IRAs: Should You Have One?
Converting traditional IRAs to a Roth.
Senior Vice President
Occasionally, Congress creates a loophole for high-income earners. In 2010, Congress changed the rules on Roth IRAs, giving all taxpayers the ability to convert traditional IRAs to a Roth IRA regardless of modified adjusted gross income or tax filing status. Unfortunately, the contribution limit to the Roth remained, and for 2014 those individuals with an annual income of more than $129,000, or $191,000 for married couples, are ineligible to open a Roth IRA.
There is no limit, however, on contributing to a non-deductible traditional IRA, or on converting a traditional IRA to a Roth IRA: thus, the “back door” contribution to a Roth IRA.
The first step in creating a back door Roth IRA is to make a contribution to a traditional IRA with your IRA custodian. Once the contribution is posted, convert it to a Roth. Because your initial contribution was non-deductible, you only pay tax on the difference between the converted value and the amount contributed, which should be trivial if you convert it immediately.
One caveat to be mindful of is that there is a pro-rata rule applicable to IRA conversions, so this strategy only works best if you do not have any other existing traditional IRA assets. For example, if you have an existing traditional IRA with a value of $45,000 and you add a $5,000 non-deductible contribution to convert via the back door, the IRS will take the $5,000 and divide it by the totality of your IRA: $50,000. In this case, the resulting calculation is 10% and therefore the other 90% of your conversion, $4,500, would be taxable.
With high-income earners paying as much as half of their income at the margin in taxes, the back door Roth, if fully executed, may be an appropriate strategy, and is being utilized by more CPAs today. As always, we recommend that you talk with your tax professional before employing this technique. Information on Roth IRA conversions is also available through a Wintrust Wealth Management Financial Advisor.
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