The backdoor to a Roth IRA is still open ‚for now
The Roth IRA was revolutionary when it became available nearly two decades ago. That’s because retirement accounts traditionally have been a method of deferring taxable income, with eventual withdrawals in retirement subject to income tax. Roth IRAs offer tax-free retirement income, and that has appealed to millions of investors.
Many high-income savers, however, don’t have direct access to Roth IRAs because of income limits on contributions. There is a way in, through the backdoor, for those who are locked out, but the backdoor may soon be closing. The Obama administration and other policymakers have put the backdoor Roth IRA strategy on the chopping block.
So if you’ve been eyeing the backdoor but haven’t stepped across the threshold, now is the time, while the strategy is still available.
So why exactly is the backdoor Roth IRA so valuable, and why do some people want it to disappear?
When Roth IRAs first came into existence, high-income individuals were shut out of the benefits a Roth IRA had to offer. Even now, single filers with adjusted gross income above $131,000 and joint filers with adjusted gross income above $193,000 aren’t allowed to make Roth IRA contributions. Conversions from traditional IRAs to Roth IRAs weren’t allowed for those with incomes above $100,000. This combination of factors created a barrier to high-income savers wanting Roth access.
In 2010, lawmakers slightly relaxed the earnings limits and repealed the income limit on Roth conversions. That opened the door to Roth IRAs for high-income individuals for the first time, but it came with a caveat.
Typically, when you convert a traditional IRA to a Roth, you have to pay income tax on the converted amount. Given how high the tax rates are for upper-income taxpayers, not many people were willing to pay up for a conversion.
Enter the backdoor Roth IRA, which gets around this problem by taking advantage of something called the nondeductible regular IRA. Most high-income individuals also can’t deduct their traditional IRA contributions because of income limits, but nondeductible traditional IRAs are available to anyone with earned income.
So, investors invented a two-step dance for the backdoor Roth that involves making a nondeductible IRA contribution and then converting that newly created IRA to a Roth.
If your nondeductible IRA is the only traditional IRA you own, then the Roth conversion doesn’t create any tax liability. That’s because the IRS recognizes the fact that you didn’t get a tax deduction for your initial nondeductible IRA contribution, and so it essentially gives you credit for that contribution when considering the tax impact of the rollover.
ViolÃƒÂ , a Roth IRA, via the backdoor.
But what if the nondeductible IRA isn’t a person’s only traditional IRA, which is the case for many retirement savers? If you have made past IRA contributions and got tax deductions from them, then the IRS requires you to treat the conversion of your nondeductible IRA as if it came pro rata (in proportion) from all your IRA assets. That means you’re stuck paying taxes on part of the converted amount.
However, there are a few ways to rearrange your finances to still use the backdoor Roth IRA strategy. Many employer 401(k) plans allow workers to roll their IRA assets into their 401(k) accounts, and money that’s in a 401(k) avoids the pro-rata tax problem because of its being an employer plan rather than an individual IRA. Similarly, those who are self-employed can use self-employed 401(k) arrangements and provide for the same asset movement to set up their tax-free backdoor Roth.
Lately, lawmakers haven’t been impressed with the cleverness of the backdoor Roth strategy. Policymakers have increasingly seen the strategy as a form of unfair tax avoidance. The Obama administration’s proposed budget for fiscal year 2016 included changes that would put a halt to the backdoor Roth IRA by preventing Roth conversions involving funds from nondeductible IRAs or voluntary after-tax contributions to 401(k) plans. The proposal is not likely to become law this time around, but in the future, lawmakers might target the backdoor Roth again.
Until then, the backdoor to a Roth IRA remains wide open. High-income individuals should eye it closely to see if they can take advantage of it. The backdoor Roth is the best — and often only — way for people subject to income limits to get the benefits of this retirement vehicle. Talk to your financial advisor to see if stepping through the backdoor is right for you.