Tax Saving Tips Beyond the Obvious: Backdoor Roth IRA

Vince Carson, CPA, Financial Planner

Hello and welcome to today’s episode of Street$marts, with Howe & Rusling. I’m Vince Carson, Certified Public Accountant and Financial Planner at Howe and Rusling. In today’s episode we are going to be going over a tax saving tip for individual tax payers to consider, that are beyond the obvious. The subject of today’s tax saving tip is the Backdoor Roth IRA.

Income taxes are, for most of us, the largest expense line item that we incur throughout the year. Therefore, with regards to your personal finance, it’s very important to address this area in order to make sure that we are utilizing all of the tax code to our advantage.

As many of you may already know, the first move in lowering your tax liability is to max out your 401(k) and IRA contributions. But what if you’ve been phased out of being able to contribute to a pretax Traditional IRA and a Roth IRA? Generally, contributions to pretax traditional IRAs and Roth IRAs are phased out for high income earners. So, what can you do if you still have excess cash on hand after funding your employer sponsored retirement account, but you still want to invest your excess money in a tax efficient method? Enter today’s tax saving strategy… the backdoor Roth IRA.

Let’s first note that the name: “Backdoor ROTH IRA” is rather misleading. This is not a shady tax strategy. This is a completely legal, and fully approved method by the IRS to fund Roth IRA contributions, through Roth conversions.

So, to reiterate, this strategy is only applicable to high income earners: those who have been phased out of being able to contribute to a ROTH IRA, the normal way.

The way that the Backdoor Roth IRA strategy works is this… Step 1: you contribute money to a non-deductible traditional IRA, which is not subject to income limitations. Now this may be a little confusing. The key here is “non-deductible”; in other words, you’re not going to get a deductible tax benefit for your contribution in the current year. Normally, when making a traditional IRA contribution, you take an adjustment on your 1040 for the amount that you contributed; therefore making that money tax deferred. In the Backdoor method, you contribute to a traditional IRA, and then don’t take the adjustment on your tax return. Step 2: You simply take the non-deductible traditional IRA, and then subsequently convert your contributed funds into a Roth IRA; making it so that money can grow tax free for life.

There are also a few additional items to note, when considering the backdoor Roth IRA.

• First, will you need the money in 5 years or less? Unfortunately, there’s a 5-year holding period associated with withdrawals of money that were part of a Roth conversion. Therefore, make sure that you won’t need the money within the next 5 years, or you could end up owing the taxes you were hoping to mitigate with the conversion.
• And two… What type of IRA assets do you currently have? You can only do these conversion strategies (tax free) if you have no other traditional IRA assets. And please remember, there are a lot of types of pre-tax IRAs… you have SEP IRAs, SIMPLE IRAs, traditional IRAs, rollover IRAs. If you have any funds in these pre-tax IRAs when you are trying to do this conversion strategy, the IRS will subject you to an additional tax on the conversion. This is known as the pro rata rule. At a high level, the pro rata rule states that taxation of IRA accounts, when converted to a Roth, is calculated as a proportion of after-tax vs before tax contributions. Therefore, if you have funds in pre-tax IRAs, doing the Backdoor Roth IRA will require additional tax forms to be filed, and is rife with the potential of tax preparation errors.
• Just because you have pre-tax IRA assets, does not necessarily mean that the Backdoor Roth IRA strategy can’t be done. It just means that you need to consider methods of emptying out those funds. This can be done either by converting all of your pre-tax IRA funds into a ROTH IRA. Or, it can be done by rolling your pre-tax IRA funds into your work 401(k) or 403(b).

So let’s recap, at a high level, the steps to consider whether the Backdoor ROTH IRA is the right strategy for you.

• Are you under the income phaseout limit? If yes, then don’t worry about this strategy! Just contribute to a ROTH IRA. Don’t make things more complicated than they need to be. However, if you are over the income phaseout limit, then
• Ask yourself: What type of IRA assets do I have? Do I have pretax traditional IRA assets? If you do, you should take pause on implementing this strategy, and consider the methods of emptying out your pretax traditional IRA assets. It’s very important to know that the backdoor Roth IRA strategy has some hair on it, and an analysis of your aggregate IRA accounts plays a key factor in determining whether this strategy is right for you.

So, if you’re interested in considering the Backdoor ROTH IRA strategy, our team at Howe & Rusling is always available to help.

Thank you so much for tuning into today’s episode of Street$marts with Howe & Rusling.