What is a Roth IRA?
The Roth IRA is perhaps one of the best retirement accounts to stash money away in. Contributions in Roth IRAs are post-tax, which means you cannot deduct it from your tax liability but the money grows tax-free and are not subject to income tax when withdrawn. There are also no required minimum distributions that are required for traditional IRAs.
The maximum annual contribution to any IRA (any combination of traditional and Roth IRA) is $5,500, or $6,500 if you are age 50 or over.¹ You must also have taxable compensation up to the dollar amount you wish to contribute for any given year.
The general consensus is, if you believe your tax rate will be lower in retirement than it is now, contribute to a traditional IRA and take the tax savings now (since you will benefit more from tax savings now than during retirement), and if you believe your tax rate will be the same or higher in retirement than it is now, you should contribute to a Roth IRA (since all distributions will be tax-free).
However, there are income limits for IRA contributions:
|2014 Traditional IRA Contribution and Deduction Limits|
|Filing Status||Income Limit||Deduction Amount|
|Married filing jointly||$96,000 or less||$5,5001|
|$96,000 to $116,000||Partial deduction|
|Greater than $116,000||No deduction|
|Single||$60,000 or less||$5,500¹|
|$60,000 to $70,000||Partial deduction|
|$70,000 or more||No deduction|
|Married filing separately||Less than $10,000||Partial deduction|
|$10,000 or more||No deduction|
|2014 Roth IRA Income and Contribution Limits|
|Filing Status||Income Limit||Contribution Limit|
|Married filing jointly||$181,000 or less||$5,5001|
|$181,001 to $191,000||Begins to phase out|
|Greater than $191,000||Ineligible for a Roth IRA|
|Married filing separately||$0||$5,5001|
|$1 to $9,999||Begins to phase out|
|Greater than $10,000||Ineligible for a Roth IRA|
|Single||$114,000 or less||$5,5001|
|$114,001 to $129,000||Begins to phase out|
|Greater than $129,000||Ineligible for a Roth IRA|
What happens if you are over the limit to contribute to a Roth IRA and take a deduction for a traditional IRA contribution?
Backdoor Roth IRA
A backdoor Roth IRA is a way for high income earners to get the benefits of a Roth IRA by converting a nondeductible IRA (because they would also be ineligible to deduct traditional IRA contributions) to a Roth IRA immediately after contributing to a nondeductible IRA. It is important to note that there is no distinction between a traditional deductible IRA and a nondeductible IRA. The only difference is whether or not you claim that contribution as a deduction when you file your taxes.
The key is to convert your contribution immediately into a Roth IRA after the transaction has posted. If done correctly, there should be minimal tax liability that is incurred due to the conversion, since no time has elapsed to build any interest. The original contributions will then be considered in a Roth IRA account and no longer subject to taxes upon distributions.
This wouldn’t be a backdoor IRA if there wasn’t a catch. The above example only works if you have no other deductible IRA balances in any IRA accounts. The IRS is smart enough to tax you on the percentage of ALL deductible IRA balances upon any IRA to Roth IRA conversion.
For instance, if you have $5,000 in a deductible IRA and this year you contribute $5,000 into a nondeductible IRA and immediately convert the $5,000 nondeductible contribution into a Roth IRA, the IRS will assume you are converting $5,000 from the sum of all traditional IRA accounts, regardless of deductible or nondeductible (converting $5,000 out of a total balance of $10,000 across all IRAs), thereby creating a tax liability on 50% of the converted amount. This means you would create a tax liability on $2,500 in this scenario. While this may certainly be worth it for some people, it is something you should be aware of when deciding whether or not a backdoor Roth IRA is a good choice for you.
Advocate under the right circumstances
Personally, I am an advocate of the backdoor Roth IRA if the circumstances are right. As a teenager and during college, I thought about the financial future regularly and contributed to a Roth IRA nearly every year. Living at home and not having very many expenses, I was able to put in the maximum as long as I made that much in income for the year. I did however, contribute to a Traditional IRA one year and screwed up a recharacterization (at the time, I thought recharacterization and conversion were synonymous – they are not), so once everything was sorted out, I was left with a $46 balance in my Traditional IRA.
This year, I managed my first backdoor Roth IRA conversion and it was surely easy enough. I also converted the $46 balance left in the IRA into a Roth IRA, so the entire conversion would be considered a 100% conversion and the additional tax liability would be on the $46 that was left over from the mistake from a couple of years ago. I’m okay with paying extra taxes on $46.
This also means, I’m contributing an extra $11,000 ($5,500 for me, $5,500 for the wife) towards retirement accounts that can’t be tapped until later years, which may reduce the amount we would be able to contribute towards early retirement.
This has yet to be seen, but will be something I will need to keep an eye on during this calendar year.
Check out my investment strategy for 2015 and let me know what you think!
As a side note, 2015 might be the last year the backdoor Roth IRA may be available to high income earners, as President Obama is trying to close this loophole with his new budget.