Important points
- Single filers can contribute directly to a Roth IRA if their income is under $168,000, while married couples filing jointly can do so if their income is below $252,000.
- The backdoor Roth process involves setting up a traditional IRA and later converting it to a Roth IRA.
- You can fund a traditional IRA and convert it just a week later.
- It’s advisable to keep traditional IRA contributions in cash until the conversion occurs.
- If you invest your traditional IRA contributions in valuable assets, that value may be taxable until conversion.
- Conversions follow proration rules, meaning the IRS considers it all as one large asset pool for tax purposes.
- If you’re part of a retirement plan that allows roll-ins, this could help avoid the tax complications associated with rollover IRAs.
Margaret Giles: Hi, this is Margaret Giles from Morningstar. While income limits exist for Roth IRA contributions, there are alternatives for high earners. Here to discuss the backdoor Roth IRA is Christine Benz, Director of Personal Finance and Retirement Planning at Morningstar. Thanks for joining me today, Christine.
Christine Benz: Great to be here, Margaret.
Income Limits for Roth IRA Contributions
Giles: Direct Roth IRA contributions aren’t accessible to everyone. Before diving into the backdoor Roth option, can you clarify the income thresholds for direct contributions?
Benz: Absolutely. The thresholds are relatively generous. For single filers, it’s $168,000, and for married couples filing jointly, it’s $252,000. If you fall under these limits, take the front-door route.
2-Step Backdoor Roth IRA Process
Giles: The backdoor Roth involves two steps.
Benz: Right.
Giles: What does that entail?
Benz: Think of it as two separate actions. First, you’ll fund a traditional IRA. Since you may earn too much for tax-deductible contributions, you just set up a traditional IRA and then convert it to a Roth later on. It’s a straightforward two-step method.
Timing for Backdoor Roth IRA Conversions
Giles: A common question is how long to wait between those two steps. Any perspective on that?
Benz: The conventional advice has evolved a bit over recent years. Initially, people recommended waiting a month or even up to a year to show legitimacy. Nowadays, the strategy seems more accepted, so there’s less concern on that front. In my case, we usually complete it within a week—funding a traditional IRA and then converting shortly after. Just keep in mind that you don’t want to delay too much since any appreciation in value would be taxable.
Investing Traditional IRA Contributions Before Conversion
Giles: Moving on, should you invest the money in a traditional IRA before converting it to a Roth?
Benz: The cautious approach suggests that you invest to demonstrate intent, but I’m not convinced that’s necessary. If you invest right away, and there’s any increase in value, you may face taxes on that gain. I’d recommend keeping the funds in cash until you’re ready for conversion, then transitioning to long-term investments.
Tax Implications of Backdoor Roth IRAs
Giles: That certainly makes sense, especially if the wait isn’t too long. Generally, conversions are taxed. How does that apply here?
Benz: It really varies depending on your situation. It’s crucial to remember two things: first, if your traditional IRA investments grow before conversion, that gain is taxable, too. Secondly, the proration rule comes into play—meaning the IRS treats your IRAs as a single asset pool for tax purposes. So even if your new IRA is small, if you have a larger, untaxed rollover IRA, that could impact how much tax you owe on conversions. Getting some tax advice beforehand is wise, especially since many people have sizeable traditional IRA balances.
Using Roll-Ins to Lower Taxes on Backdoor Roth IRAs
Giles: Is there a strategy for those with substantial traditional IRA balances wanting a Roth conversion?
Benz: Yes. If your work’s retirement plan allows for roll-ins, moving external assets into that plan can be a great strategy. This helps eliminate rollover IRAs, which can bring tax complications. By including those assets in your 401(k), you can effectively remove them from the pro-rata calculations mentioned earlier. Just be sure to research your options carefully and ensure you’re contributing to a quality plan with good investment choices. It’s a solid workaround for those in this predicament.
Giles: That’s a helpful perspective on utilizing the backdoor route for Roth IRAs. Thanks for your time, Christine.
Benz: Thank you, Margaret.
Giles: I’m Margaret Giles from Morningstar. Thanks for joining us.
For further information, check out 4 Easy Ways to Increase Your Safe Withdrawal Rates by Christine Benz and Margaret Giles.
