Demystifying backdoor Roth IRA conversions
Last week, we talked about this year’s July 15 deadline for 2019 IRA contributions. July 15 is also an important date for “backdoor” Roth conversions for people who don’t qualify for Roth contributions.
That is, if you haven’t made your 2019 IRA contribution, and you don’t qualify for a Roth contribution due to income limits, consider doing a backdoor Roth for 2019 and, while you are at it, do one for 2020. That way, you can contribute a maximum of $6,000 ($7,000 if you are 50 or older) for each tax year, for a total of $12,000 ($14,000).
When you convert, you will have to pay taxes on the amount converted, except in a special situation that I’ll describe shortly.
What’s “backdoor” about the conversion?
If you earn over a certain dollar amount, you cannot make a direct Roth IRA contribution. The back door is a contribution to a traditional IRA followed by a conversion to a Roth.
What are the income limits that prevent a direct contribution to a Roth? That depends on your filing status.
For example, if you are single with a modified adjusted gross income (MAGI) of $137,000 or more (2019), then no Roth contribution for you. The max for 2020 for single filers is $139,000. The limits are higher if you are married and filing jointly ($203,000 for 2019 and $206,000 for 2020).
Limits are published in IRS Pub. 590-A, which you can read online at irs.gov/ pub/irs-pdf/p590a.pdf.
Why would you want a
Roth? Roth IRAs are taxfree, not tax-deferred. There are no required minimum distributions (RMDs) during your lifetime. And when you withdraw the funds (after age 59 ½ and a holding period of five years), there is no tax bill. In the ideal case, the backdoor Roth can even be taxfree.
Take this example: John, age 52, is single. He earned $160,000 in 2019 and expects to earn about that amount or more in 2020, which means his income is above the limit for Roth contributions.
He cannot contribute to a Roth, but he can contribute to a traditional IRA. He has made no 2019 or 2020 IRA contributions to date, and in fact does not have an IRA. He wants to maximize his Roth opportunities.
John opens up a traditional IRA at a brokerage firm, as well as a Roth IRA. He contributes nothing to the Roth. He contributes $7,000 to the traditional IRA for the 2019 tax year before July 15. At the same time, he contributes $7,000 to the traditional IRA for the 2020 tax year.
He can do these contributions because there are no income caps on traditional IRAs. The Roth IRA he opened is not funded — yet.
But now that he has $14,000 in his traditional IRA, he directs the brokerage firm to convert his traditional IRA to a Roth IRA. In this very limited example, the conversion is tax-free.
If John had other traditional IRAs, he would have to pay taxes on the conversion because of “aggregation”
and “pro rata rules.”
Here is how Fidelity describes these rules:
“When it comes to conversions ... the IRS views all of your traditional IRAs as one account. If you have three traditional IRAs and a rollover IRA spread across different financial institutions, the IRS would lump all of them together.”
The accounts are aggregated and the conversion must be done pro rata — “proportionally split between your after-tax and pre-tax balances, including contributions and earnings,” according to Fidelity.
It might be clearer to see an example of this in action, which you can find here: fidelity.com/view points/retirement/earn-toomuch-contribute-RothIRA-conversion.
In any case, now is a good time to fund a Roth IRA, either through the back door or directly if you qualify.
For more reading on backdoor IRAs, a good resource is forbes.com/ sites/jimwang/2020/ 02/20/supercharge-yourretirement-savings-with-abackdoor-roth-ira/ #5753a74a8f08.
July 15 is almost here, so make sure to take care of your 2019 IRA contributions — and your 2019 income tax return — before the deadline.