Backdoor Roth IRA Rollovers

By | March 23, 2015

What is a Backdoor Roth IRA?

The backdoor Roth IRA can be very effective for saving for retirement in a tax efficient manner. For tax years beginning after 2009, the $100,000 modified AGI limit on conversions to Roth IRAs no longer applies, and for the first time, married taxpayers filing separately may make rollovers to Roth IRAs. (Before 2010, only those taxpayers with modified adjusted gross income (MAGI) of $100,000 or less could have converted amounts in a traditional IRA (or qualified plan) to amounts in a Roth IRA, and married persons filing separately couldn’t make those rollovers at all). This makes the backdoor Roth IRA and very powerful retirement savings tool.


Backdoor IRA Rules for 2015 and 2016

In 2015, you may roll over amounts in qualified employer-sponsored retirement plan accounts, such as 401(k)s and profit sharing plans, and regular IRAs, into Roth IRAs-regardless of your adjusted gross income (AGI). You will need to file information on your 2015 tax return about the Roth conversion. This will all be post-tax income.


What are the benefits of a Roth IRA?

There are many different benefits to using a Roth IRA to save for retirement. Below area few of the benefit which may make doing a Roth conversion of backdoor Roth contribution beneficial.

  • Earnings within the account are tax-sheltered (as they are with a regular qualified employer plan or IRA).
  • Unlike a regular qualified employer plan or IRA, withdrawals from a Roth IRA aren’t taxed if some relatively liberal conditions are satisfied.
  • A Roth IRA owner does not have to commence lifetime required minimum distributions (RMDs) after he or she reaches age 70 1/2 , as is generally the case with regular qualified employer plans or IRAs.
  • Beneficiaries of Roth IRAs also enjoy tax-sheltered earnings (as with a regular qualified employer plan or IRA) and tax-free withdrawals (unlike with a regular qualified employer plan or IRA). They do, however, have to commence regular withdrawals from a Roth IRA after the account owner dies.


Why do a Roth Conversion?

The catch, and it’s a big one, is that the rollover will be fully taxed, assuming the rollover is being made with pre-tax dollars (money that was deductible when contributed to an IRA, or money that wasn’t taxed to an employee when contributed to the qualified employer-sponsored retirement plan) and the earnings on those pre-tax dollars.

For example, if you are in the 28% federal tax bracket and roll over $100,000 from a regular IRA funded entirely with deductible dollars to a Roth IRA, you’ll owe $28,000 of tax. So you’ll be paying tax now for the right to future tax-free withdrawals, and freedom from the RMD rules.


When to make Roth IRA Conversion?

The answer may be “yes” if:

  • You can pay the tax on the rollover with non-retirement-plan funds. Keep in mind that if you use retirement plan funds to pay the tax on the rollover, you’ll have less money building up tax-free within the account.
  • You anticipate paying taxes at a higher tax rate in the future than you are paying now. Many observers believe that tax rates for upper middle income and high income individuals will trend higher in future years
  • You have a number of years to go before you might have to tap into the Roth IRA. This will give you a chance to recoup (via tax-deferred earnings and tax-deferred payouts) the tax hit you absorb on the rollover.
  • You are willing to pay a tax price now for the opportunity to pass on a source of tax-free income to your beneficiaries.


Who is Ineligible for Backdoor Roth?

Individuals ineligible to make deductible contributions to a traditional IRA, or to make any regular contributions to a Roth IRA, due to limitations based on adjusted gross income, may contribute to a traditional IRA and then convert this amount to a Roth IRA. So individuals who have never opened a traditional IRA because they weren’t able to make deductible contributions (and who have never rolled over pre-tax dollars to a regular IRA) should consider opening such an IRA and making the biggest allowable nondeductible contribution they can afford.


What is the effect of a Backdoor Roth?

If they convert the traditional IRA to a Roth IRA they will have to include in gross income only that part of the amount converted that is attributable to income earned after the IRA was opened, presumably a small amount.


Nondeductible IRA Contributions

They could continue to make nondeductible contributions to a traditional IRA in later years, and roll the contributed amount over into a Roth IRA. However, note that if an individual previously made deductible IRA contributions, or rolled over qualified plan funds to an IRA, complex rules determine the taxable amount.


How to Track Nondeductible IRA Contributions

There also are many details that we should go over, such as whether the amounts you are thinking of switching to a Roth IRA are eligible for the rollover (technically, they are called “eligible rollover distributions”), whether you can make rollovers from your employer sponsored plan (for example, there are restrictions on rollovers from 401(k) plans), and the tax impact of rolling over amounts that represent nondeductible as well as deductible contributions.