A backdoor Roth IRA is a legal way for the high-income earners to contribute to Roth IRA.
In general, IRA (Individual Retirement Account) is a tax-advantage vehicle toward retirement savings. There are different types of IRAs; however, this blog post will focus on Traditional IRA and Roth IRA as they are related to the Backdoor Roth IRA
- Traditional IRA
- Roth IRA
Traditional IRA and Roth IRA are tax-advantage retirement savings.
- In general, a taxpayer can withdraw any types of IRAs before the age of 59 ½. However, the withdrawal amount will be subjected to an individual income tax and an early-withdrawal penalty of 10%
- Income limits and maximum contributions for IRAs change every year. For 2020 and 2019, the contribution limit is $6,00 ($7,000 if you’re age 50 or older)
- There is Income limitation for contributing to Roth IRA and deduction to traditional IRAs
- An individual can contribute to both IRA and Roth IRA (if eligible). However, the total contribution will subject to the maximum contribution
The main difference between Roth and traditional IRAs lies in the timing of their tax advantages. For traditional IRAs, the contributions can be deducted (pre-tax) in the same year of the contribution made and the withdrawals will get taxed later; However, for Roth IRAs the contribution can’t be deducted (post-tax) in the year of contribution made and withdrawals will get tax-free later.
Why Roth IRA?
Often Roth IRA is preferred over the transitional IRAs
- Roth IRA is not subjected to required minimum distributions (RMD) starting the age of 72 while traditional IRA is subjected to this rule.
- RMD: a minimum amount of money needs to be withdrawn from retirement accounts. The minimum amount is specified by IRS each year. The distribution is taxed based on the tax rate in the distribution year and a 50% penalty is imposed on the rule violation.
- For Roth IRA, since the contribution is post tax amount, the contribution (not the earnings) can be withdrawn any time at any age without penalty nor tax.
- For Roth IRA, a qualified distribution (age of 59 ½ or over), the withdrawals (both contribution and earnings) will be tax-free and penalty-free while the traditional IRA qualified distribution will be penalty-free but taxed based on the tax rate of the year of distribution.
Why Backdoor Roth IRA?
Backdoor Roth IRA is a legal technique to contribute to Roth IRA for high-income individuals who are not allowed to contribute to traditional IRAs or Roth IRA. American IRA’s expert has a nice summary table for the 2019 Roth IRA eligibility as below.
From the table, a married couple whose income over $203,000 (2019) is not eligible to contribute to Roth IRA. Therefore, backdoor Roth IRA technique can be used to contribute to Roth IRA.
Easy Steps for Backdoor Roth IRA
- Make a nondeductible contribution (post-tax money) to a traditional IRA
- Convert the traditional IRA to a Roth IRA. The conversion from the contribution will not result in any taxable income, only the earnings during the time from contribution to conversion period will result in taxable income
I have found Vanguard make it easy for backdoor Roth IRA procedure as the whole process can be done online. A steps-by-steps captures are shown below:
Step 1: Open a traditional IRA and contribute $6,000 of post-tax money to the account.
Please follow the instruction on the screen to complete the process of opening a tradition IRA account. Below is the screen capture for the last funding step.
Now the transitional IRA account is open and funded with a nondeductible of $6,000 (maximum 2020 contribution for under 50 year-old individuals
It will take few days for the new traditional IRA account with $6,000 showing up on Vanguard. After that, a conversion can happen.
Step 2: Convert the traditional IRA to a Roth IRA
- If you don’t have an existing Roth IRA account, you can open a new Roth IRA account then convert $6,000 from the IRA to Roth IRA
Follow the instruction on the screen to continue the process
Congratulations !!! Backdoor Roth IRA process is now completed. Since both traditional IRA and Roth IRA accounts are already open, the existing accounts for traditional IRA contribution and Roth IRA conversion can be used for future years, no need to open new accounts.
Cautions
- Step 1 is for contribution to a traditional IRA. Traditional IRA is subjected to RMD; therefore, an individual needs to be younger than 70 ½ by the end of the contribution year.
- The nondeductible contribution for the current year can be made by April 15th or the tax filling deadline of the following year. The conversion can take place anytime after contribution is processed.
- December 31st of the tax year is the deadline for the backdoor Roth IRA conversion to dispose of other traditional IRAs which are still in balance. If there is still any traditional IRA balances on December 31st, then the pro-rata rule will apply to the conversion.
- Traditional IRAs can be rolled to Roth IRA, 401(k) or 403(b) at work if it takes the rollover.
- Pro-rata Rule example: if an individual makes a backdoor Roth IRA contribution of $6,000 and having a traditional IRA with a pre-tax balance of $20,000, then only 23.1% or $1,385 ($6,000 / ($20,000 + $6,000)) of the conversion will be tax-free and the remainder of $4,615 ($6,000 * (1 – 23.1%)) will be taxable income.
Tax Filling
The nondeductible contribution is reported on the form 8606 for the tax year of contribution, but no tax impact. The conversion will be reported for the year in which it happened (along with the carried-forward basis).
To report a backdoor Roth IRA in the tax software, navigate to the IRA contribution first. Please do not choose Roth IRA contribution but choose traditional IRA contribution. Once traditional IRA contribution is complete, navigate to income section and choose 1099-R distribution . Be careful to enter exact information from 1099-R form (1099-R is provided by the IRA brokerage). This step is to convert traditional IRA to Roth IRA. After that, form 8606 will be generated, you can review if the information on 8606 form is correct.
References
- 2019 Roth IRA Eligibility
- 2019 Traditional IRA Deduction
Khanh Le, preferred name as Jessica Le, is a licensed Certified Public Accountant (CPA). Jessica also earned a Master of Business Administration (MBA) from San Jose State University.