Back-Door Roth IRAs

In 2021, taxpayers have an option to fund either a traditional IRA or Roth IRA, up to the maximum limit of $6,000 ($7,000 if you are age 50 or over). Both are good options, with different treatments. The traditional IRA lets you choose to deduct the contributions; however, future distributions are taxed at the then current tax rates. Roth IRAs work differently as there is no deduction on the contributions, likewise, there is no tax when amounts are taken out. Further, Roth IRA does not require Required Minimum Distribution (RMD) and Roth IRAs can be passed down tax free to heirs. 

The obvious caveat to the above is that for high income taxpayers —defined as the 2021 adjusted gross income (AGI) over $140,000 for individuals and over $208,000 for married filing jointly—contributions to Roth IRAs are disallowed. While there are AGI limits on deductions for traditional IRA contributions, there are no limits on contributing to a traditional IRA without taking a deduction (known as nondeductible contributions).

Back-Door Roth IRA conversion:

This strategy, under current tax laws, allows the taxpayer to fund their Roth IRA via the nondeductible IRA route.  Simply put, the high-income taxpayer would contribute to their traditional IRA as a nondeductible amount. As this amount is not deducted on their tax return, they have tax basis in their contribution. Once this is established, then the taxpayer can convert the nondeductible contribution into a Roth IRA, without paying any tax on the conversion.  Please note, if between the time you contribute to your IRA and convert to your Roth, the balance increases due to the market changes, then any gains above your basis is taxed. This strategy can be used yearly. Most of our clients usually leave the money in a cash account and then convert it soon after, so the increase in the balance is insignificant. 

Pitfall:

The above is the simple version that assumes this is the only IRA held by the taxpayer. However, there is a large pitfall you should watch out for as it can produce unexpected taxable income. When you convert your IRA to Roth IRA, the IRS views all your IRAs together as one pool to be converted (not an account-by-account basis, nor by deductible/nondeductible buckets).

Therefore, if you have other traditional IRAs that have both deductible and nondeductible contributions, then a portion of your conversion will be subject to tax. 

Example: Mary has $7,000 in an IRA from many years ago, when she was able to take a deduction on her contributions. In 2021, her AGI is $215,000, and she cannot contribute to a Roth or deduct any IRA contributions, so she decides to fund her IRA with a nondeductible contribution of $5,000. Five months later, she converts the $5,000 she contributed as a nondeductible IRA. On her tax return, she will have $2,917 that is subject to tax. This is the pro-rata of both the deductible and nondeductible portions of all her IRA accounts (at all brokerages). In Mary’s case, the total IRA balance is $12,000, her deductible portion is $7,000 and she converted $5,000.

$7,000 / 12,000 = 58.33% that is the taxable portion.
               $5,000 * 58.33% = $2,917 amount that is taxable on her return based on $5,000 converted.

There is a way to maneuver around this, which would involve rolling over the deductible IRAs to an employer plan (if allowed), but it does add complication and would be dependent on a few factors specific to the taxpayer.   

The rules on creating the backdoor Roth IRA are complex. Cray Kaiser is here to help if you have further questions about utilizing the backdoor Roth IRA strategy. Please contact us today at 630-953-4900.