Implementing a “Backdoor Roth” strategy is a terrific way to build after tax retirement balances. Roth IRAs allow for annual non-deductible IRA contributions which grow tax-free and there are never any required distributions as with a tax deductible IRA. This makes Roth IRAs a very appealing savings option for those who are looking for additional retirement savings.
However, if you earn more than $139,000 in 2020 ($206,000 Married Filing Jointly), you do not qualify to make a direct Roth IRA contribution. Fortunately, there is a way to work around this. It is a technique known as a “Backdoor Roth.” With this strategy you first open a traditional IRA and make a non-deductible contribution ($6,000 in 2019 and 2020 or $6,000 with $1,000 catch-up if 50 or over). Then transfer (convert) the balance owed to a Roth IRA. If you have previously converted your tax deductible IRAs to Roth IRAs, this is a no-brainer as there will be no taxable income due on the conversion.
The calculation of income tax upon conversion becomes more costly if you have other holdings in a traditional IRA. Money converted may be subject to current tax by virtue of the “pro-rata rule.” When you convert IRA accounts to a Roth, you must factor in all of your IRA assets (not just the new non-deductible contribution) to determine taxability. For example, if you have $120,000 in a traditional IRA from a 401(k) rollover, and you make two nondeductible $6,000 contributions (2019 and 2020) totaling $12,000 to a new Roth IRA, the conversion would be 90% taxable.
If you have questions about this technique or how it might affect you personally, please discuss this with your CPA or contact us for further assistance.
Horizon Wealth Advisors is a Houston based fee-only wealth management firm. Horizon is a fiduciary advisor. We specialize in helping successful individuals and families understand, organize, and manage their often complex financial situations. Horizon offers integrated financial planning and investment management services.