What If You Don't Qualify For A Roth IRA? Part II

by: Russ Thornton

What is a Backdoor Roth IRA?

Is It Legal? And Will I Owe Taxes?

How Do You Create a "Backdoor" Roth IRA?

Why Would I Want a Roth IRA?

Recently, I put together a post: What If You Don't Qualify for a Roth IRA? I got some fantastic feedback from readers, but many of them had the same question that kept coming up:

What about a backdoor Roth IRA? Is that an option I should look at, too?

So, today we're going to extend the original post to a "part two" specifically to cover what a backdoor Roth IRA is, whether or not it's legal, how it's created, and what the tax consequences or financial benefits are.

What is a Backdoor Roth IRA?

A backdoor Roth IRA is the conversion of nondeductible, after-tax contributions from a Traditional IRA to a Roth IRA. Few people realize that after-tax contributions to a Traditional IRA are even possible - because it's so often viewed as a pre-tax contribution account that lowers your current taxable income.

That being said, anyone can convert after-tax money that they've been saving in a Traditional IRA to a Roth IRA - and there are no income restrictions. This helps savers conveniently side-step the income restrictions that come along with a Roth IRA.

In 2019, if your modified adjusted gross income (MAGI) is:

  • $137,000 (single)
  • $203,000 (married filing jointly or a qualifying widower)

you aren't allowed to contribute to a Roth IRA.

However, for many people who are proactively saving for retirement, contributing to a retirement savings account (a Roth IRA) with after-tax funds, then not having to have those funds taxed during retirement, is very appealing.

This is especially true for younger savers who have a longer timeline before they retire and expect to retire in a higher tax bracket than the one they're currently in, and for savers who may be closer to retirement but still want to reap the benefits of tax-free retirement savings growth in a Roth IRA.

Is It Legal? And Will I Owe Taxes?

Yes, a Backdoor Roth IRA is legal. However, it's important to remember that this isn't a way to completely skip out on your taxes. Money that's been converted from a Traditional IRA to a Roth IRA will still be taxed at your current income tax rate if taxes haven't been previously paid on this money (this is typically any untaxed growth and earnings on your -tax contribution). This could bump you up into a higher tax bracket during the year that you undergo the conversion, so be aware of this.

However, when you're contributing a relatively small sum to a Traditional IRA each year and planning to convert it to a Roth IRA - this point becomes moot. The income taxes you'll pay on capital gains earned from $6,000 of after-tax contributions, for example, are relatively minimal. The after-tax growth you'll experience on those funds in a Roth IRA is definitely worth the small amount you may owe in capital gains taxes after your conversion.

How Do You Create a "Backdoor" Roth IRA?

To create a "backdoor" Roth IRA, you follow the following steps:

  1. You make a non-deductible contribution of after-tax funds to a Traditional IRA.
  2. You convert those funds to a Roth IRA - and pay whatever taxes you may owe on the gains earned from those contributions.
  3. You watch your savings grow tax-free until you retire. And even then, you can access and spend these funds tax-free. That's the primary benefit of a Roth IRA.

Did you know that you can do this conversion process regularly - sometimes even annually - with no penalties? There's no one-time limit, and this opens up the ability for you to contribute non-deductible funds to a Roth IRA - even if your MAGI disqualifies you from contributing to one directly. Just be sure you don't exceed the annual contribution limit for an IRA in any one tax year.

This concept is truly the "backdoor" part of the Traditional → Roth IRA conversion. Because your funds won't really grow that much over the course of the year, any taxes you'd owe on the capital gains earned on your contributions to a Traditional IRA would be minimal. Then, when you convert the funds to a Roth IRA, they can continue to grow and ultimately be used tax-free.

For many people, this is an ideal situation. They get all the benefits of tax-free growth, and the process of converting after-tax contributions from a Traditional → Roth IRA is relatively straightforward - making the process tough to shake a stick at.

Why Would I Want a Roth IRA?

Roth IRAs aren't necessarily the end-all-be-all retirement savings vehicle. This is, for the most part, because their contribution limits are relatively small in comparison to a 401k, or other traditional retirement savings route that you might take. For 2019, you can only contribute $6,000 to your Roth IRA. And if you make over the specified MAGA (listed above), you can't contribute at all.

Also, if you age 50+, you can contribute an extra "catch-up" contribution of $1,000 to your IRA each year for a total of $7,000.

So, what purpose does a Roth IRA serve?

When you create a backdoor Roth IRA, you're allowing all of the funds you've accumulated to continue growing tax-free indefinitely. Contributing after-tax funds to your Traditional IRA with the intent to convert them to a Roth at the end of the year may make sense for your unique financial situation.

You're freeing yourself up to continue growing your retirement savings tax-free without having to pay a mass sum of money in taxes on pre-tax contributions that you're "rolling over" into a Roth IRA.

One final note: Roth IRAs aren't subject to Required Minimum Distributions which start at age 70 1/2 for traditional IRA accounts. Many people consider this another benefit of Roth IRAs over Traditional IRAs.