As Financial Advisors, we are often asked questions that arise after clients see a video on social media, read an intriguing headline or news article, or overhear a conversation about an investment related topic. One of those hot topics that has been coming up regularly has been around Roth IRA conversions or “backdoor Roth IRAs”. In this article, we have laid out the basics steps in the process of a Roth conversion or making a “backdoor Roth IRA contribution”.
To get started, there is actually no special account titling or account name for a backdoor Roth IRA or Roth conversion. There are simply traditional IRAs and Roth IRAs. Here’s a simplified breakdown of how the process works, without any slang terminology or fancy language:
- Contribute to a Traditional IRA: Regardless of your income level, you can make a non-tax deductible contribution to a traditional IRA. Unlike deductible traditional IRAs, these contributions are made with after-tax dollars and are not tax-deductible.
- Convert to a Roth IRA: Once your funds are in the traditional IRA, you can convert them into a Roth IRA. This conversion is permissible because Roth conversions have no income limits. You can do this via a rollover within 60 days, or a direct trustee to trustee transfer.
- Tax Considerations: While the initial contribution to the non-deductible traditional IRA is made with after-tax dollars, any earnings in the non-deductible traditional IRA and the converted amount may be subject to taxes at the time of conversion. However, if you convert promptly after making the contribution and there are minimal earnings, the tax impact is typically negligible. Also, keep in mind that you must wait five years to take tax-free withdrawals from the Roth after a rollover, even if you’re already age 59 ½.
- Check IRA Pro-Rata Rule: If you have other traditional IRAs with pre-tax contributions, the IRS will apply the Pro-Rata rule, impacting the tax consequences of a conversion. Consult a tax professional to understand how these rules apply to your situation.
- Consult with a Financial Advisor: Given the complexities and potential tax implications, seeking guidance from a financial advisor or tax professional can ensure you navigate the process correctly and optimize the benefits of a Roth Conversion.
How might a Roth conversion or “Backdoor Roth IRA” benefit you?
- No Required Minimum Distributions (RMDs) from Roth IRA or Roth 401K accounts: With a traditional IRA, the government mandates that you start taking distributions from the account, according to your date of birth. The reason for this is that the money in a traditional IRA has not been taxed yet, and the IRS will only allow a deferral of their tax revenue for so long. Under current tax law, there is no requirement to take a distribution from a Roth IRA or Roth 401K.
- Tax free withdrawals: After the conversion, the funds in your Roth IRA can be withdrawn tax free. This includes the growth in the account, as long as the Roth IRA account has been open for 5 years, and you are over age 59 ½.
- Lifetime deferral and estate planning: With a Roth IRA, the account can grow tax free and is not subject to RMDs, which could allow you to grow the assets for your life, then pass the account to your heirs tax free. If your heir is your spouse, they can assume the account as their own and continue the tax free growth and deferral period. There are special distribution rules for non-spousal beneficiaries, and these rules have been changing lately, so please contact an advisor for current guidance.
- A “bridge” to retirement: Hypothetically, say you wanted to retire before age 59 ½, and you need to utilize one of your retirement accounts to accomplish that goal. As long as the Roth IRA has been open for 5 years, you can take your contributions out of the account tax and penalty free. Taking the contributions out of the account may help you “bridge” the gap between your retirement date and age 59 ½, when the early withdrawal penalty no longer applies. An important consideration here is recordkeeping, as you need to be careful that you take the contributions out only- not the growth, or you could incur an early withdrawal penalty on the growth in the account if it is withdrawn.
