Roth IRAs are typically off limits for many higher-income earners, due to strict income caps on contributions. However, there is another way into a Roth, the back-door method. Using this method, you open a traditional IRA, make a nondeductible contribution and then, at a later date, covert the funds into a Roth IRA.
The appeal and limitations of a Roth
With a Roth IRA, you get no up-front tax deduction. However, you pay no tax on either principal or earnings when you withdraw your money (as long as you are 59 ½ and have had the Roth for at least 5 years). There is also no time requirement on when you must withdraw the funds.
The problem is Roth IRAs are only available to those whose annual income is below certain levels.
The Back-Door method
The two-step process goes like this:
Paying the taxes due
The Roth conversion triggers income tax on the appreciation of the after-tax contributions. If you have no other IRAs, figuring out your tax due will be simple. However, it can be much more complicated if you do have other IRAs. The IRS’s pro-rata rule requires you to include all of you traditional IRA assets (both pre and post-tax contributions). Then, you pay a proportional amount of taxes on the original accounts pretax contributions and earnings. Below is an example from Charles Schwab:
Say you contribute $5,500 to a nondeductible traditional IRA. You also have a rollover IRA worth $94,500 from a previous 401(k) made with pretax contributions. In this case, 94.5% of any conversion would be taxable. Here’s the math:
The back-door Roth is not for everybody. Factors like other IRA assets and your tax bracket must be considered before deciding to go through with one. We recommend that you consult with an advisor and a tax professional when considering a back-door Roth.
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