The Basics
Disclaimer: This article is for information purposes only. Please do not preform a back-door Roth IRA conversion without the help of a financial professional.
When saving in a Roth IRA, your contributions are taxed and your distributions are tax-free. This makes Roth IRAs unique amongst retirement accounts and a valuable part of many retirement plans.
But, these benefits come at a cost. Many high-income taxpayers are prohibited from using Roth IRAs because of its income limitations. In 2016, an unmarried taxpayer cannot contribute to a Roth IRA if their income is over $132,000 and joint-filers cannot contribute to a Roth IRA if their income is over $194,000.
You can check the 2016 Roth IRA income limits here or check the 2017 Roth IRA income limits here.
High-income taxpayers can circumvent these limits with a ‘back-door Roth IRA, ‘ which converts a traditional IRA into a Roth IRA. These conversions do not have the same income limitations as direct contributions.
Problems with Back-Door Roth IRAs
In practice, back-door IRAs are much more complex and come with their fair share of potential tax problems. Some of these problems include whether the original traditional IRA contribution was deductible, when the original contribution was made, and how much the account holdings have appreciated.
The biggest problem with back-door Roth IRAs involves the legal structure of traditional IRAs. All traditional IRAs that a taxpayer owns, even if they are at different brokerages, are considered one IRA in the eyes of the law. Any distributions or conversions from any traditional IRA are proportionately taken from both the deductible and non-deductible portion of the traditional IRA. The deductible portion would be taxed when distributed or converted.
There is a possible, albeit complex, work around which involves transferring a portion of the traditional IRA into an employer retirement plan. After transferring part of the account, the back-door conversion can be done with the remainder.
We’ve only scratched the surface of back-door Roth IRA conversions. They are incredibly complex and should only be done with the help of a financial or retirement professional. If you don’t have one, I can recommend a few that can help safely perform a back-door Roth IRA.