By Cathy Miller
I remember one of my grandmother’s favorite sayings was, “When you can’t come in the front door, don’t be afraid to go in by the back door.” This saying perfectly captured this amazing woman’s outlook on life - that we should never give up, and need to be creative to find solutions to the “curve balls” life can throw our way.
Little did I know that this advice would someday apply to the complex world of retirement planning. For those of you who have heard of “back door Roth IRA contributions,” the connection may be getting a little clearer.
First, you might want a refresher on how a Roth IRA differs from a traditional (deductible) IRA. Traditional IRA contributions are tax deductible on both state and federal tax returns for the year you make the contribution, while withdrawals in retirement are taxed at ordinary income tax rates. Roth IRA’s provide no tax break for contributions, but earnings and withdrawals are generally tax-free. So, with traditional IRA’s, you avoid taxes when you put the money in. With Roth IRA’s, you avoid taxes when you take it out in retirement. One factor you should consider when deciding between a traditional IRA or a Roth IRA is whether you expect your tax rate in retirement to be higher or lower than your current tax rate. In other words, is it more valuable to get a tax deduction now when you make your contribution, or avoid taxes when you withdraw money at retirement (especially since that should be a much larger amount at that time)?
Another factor to consider is whether the law even allows you to make a contribution to one type of IRA or another. Contributions to traditional deductible IRA’s are only tax deductible if your income falls within a certain threshold (which varies based on the year and your filing status). Individuals with income over the limit can still contribute, but amounts are not deductible, so this type of IRA is called a non-deductible IRA. A similar income phase-out exists for those wanting to contribute to Roth IRAs; once income reaches a certain limit, the opportunity is no longer available.
The Back Door
This is where my grandmother’s advice to try the back door comes into play. This “backdoor” is made possible by the Tax Increase Prevention and Reconciliation Act of 2010, and allows individuals who normally make too much money to contribute to a Roth IRA, to put money into a Roth indirectly.
Although the 2010 tax act retained income limits on Roth IRA contributions, it eliminated the income limits on Roth IRA conversions. As a result, anyone who earns too much to contribute to a Roth IRA (and to make tax-deductible contributions to a traditional IRA) can now fund a Roth by making a nondeductible contribution to a traditional IRA and then converting that amount to a Roth—in some cases, tax-free.
Known as a “backdoor Roth IRA contribution,” this strategy can be highly effective for creating tax-free income in retirement, but can be a bit complicated. So, it is important to understand the rules and who it is likely to benefit.
There are many benefits to accumulating retirement assets in a Roth IRA, including:
- Tax-free growth
- Freedom from required minimum distributions, so assets can grow tax-advantaged for a longer period of time
- The ability to put more money away for retirement.
Take a married couple in their 40s who file jointly. Both employed, they have maxed out their 401(k) contributions, but neither of them contributes to a deductible IRA contribution or Roth because their income puts them over the applicable limits. Because their retirement goals are aggressive, they need to find a way to catch up on their savings. What can they do?
They can each make a $5,500 nondeductible IRA contribution and immediately convert it, tax-free, to a Roth IRA. Hypothetically, if each of them contributes $5,500 annually with this backdoor strategy, with a conservative rate of return of 5 percent*, over 20 years they each could potentially accumulate $190,956. And that money will never be subject to federal or state income tax.
Even though this strategy can, in some ways, benefit almost anyone, your individual circumstances need to be carefully considered. It is especially important to proceed carefully if you have other existing IRA’s, one or more of which have a mix of after-tax and pre-tax dollars. For that reason, we encourage you to reach out to your Atlanta Financial advisor as well as your tax preparer to see if “going in the back door” seems like the right approach for you.
Catherine Miller is the Principal at Atlanta Financial Associates, Inc. located at 5901-B Peachtree Dunwoody Road, Suite 275, Atlanta GA, 30328, ph# (770) 261-5382. Catherine offers securities through Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. Advisory services offered by Atlanta Financial Associates Inc. are separate and unrelated to Commonwealth. Fixed insurance products and services offered through Atlanta Financial Associates, Inc. or CES Insurance Agency.
*This is a hypothetical example and is for illustrative purposes only. No specific investments were used in this example. Actual results will vary. Past performance does not guarantee future results.