This blog is a repeat of the topic of a Back Door IRA. The reason I bring it up again is that Mega-Back Door Roth IRAs have been in the news a lot lately. I’ll discuss those next week but thought we should all be on the same page of what the Not-Mega (aka Regular) back door Roth IRA is first. Making an appearance from last November, here you go:
- Roth IRAs allow you to contribute up to $6,000 per year ($7,000 if you are aged 50+) to an IRA that grows tax-free for retirement. You do NOT get an up-front tax deduction on the contribution.
- A tax-free pot of money to withdraw from during retirement will make you happy.
- Not everyone is allowed to contribute to a Roth IRA. If you are married with modified adjusted gross income over $206,000 in 2020 or single with modified adjusted gross income of over $139,000, you cannot contribute to a Roth IRA.
Or can you? Let’s do the IRS fancy-dance around their own limitations.
A Traditional IRA allows people of any income to contribute up to $6,000/year ($7,000 if aged 50+). The money grows tax-DEFERRED (income tax paid upon withdrawal), which is less cool than tax-FREE. So, Richie Rich, go ahead and make that Traditional IRA contribution and don’t deduct it on your income taxes. You wouldn’t be allowed to anyway. More IRS rules, blah, blah, look it up on www.irs.gov.
Do a Roth Conversion to move that Traditional IRA money to your Roth IRA. There is no income limitation to doing Roth Conversion. This is the sneaking in the back door part.
A Roth Conversion means you pay income taxes on the tax-deferred money you convert in that year. If you have an IRA that only is a landing spot for non-deductible IRA contributions, the tax bill on the Roth Conversion would be $0 if done immediately after the IRA contribution was made and there was no growth in the account. Sounds good.
Before you dip your partner and end the dance with a passionate smooch…
Step three and a half:
Here is where it gets tricky. If you have ANY other Traditional tax-deferred IRAs out there (like a Rollover IRA from a previous employer), you have to pay income tax on the percentage of your total IRA balances vs the Roth conversion portion.
For example, say you have $100,000 in a Rollover IRA and you want to do a $6,000 backdoor Roth IRA contribution. Ninety four percent of your $6,000 Roth Conversion would be taxable. In other words, $5,640 would be added to your income for tax purposes to do this conversion.
Whether doing Roth conversions or back-door Roth contributions is a very personal decision. Don’t let financial media convince you that what’s good for some people is something you MUST do. Talk to your financial and tax advisors before going down this road.