The Roth IRA is one of the best retirement vehicles around:
- Once your money gets into a Roth IRA, it grows tax deferred.
- At (or after) age 59½, as long as you first funded your Roth IRA at least five years previously, you can withdraw the money completely tax-free.
- Unlike with many other retirement accounts, you're never required to take a distribution from your Roth IRA, even if you live to be 120.
- Once you do pass away, your heirs can also take the money out from the account without paying additional income taxes, making the Roth IRA one of the most potent estate tools out there.
The only problem with a Roth IRA is that not everyone qualifies to contribute directly to one.
Fortunately, there are often ways to get money into such an account without directly contributing to it -- creating the concept of a "backdoor Roth IRA."
Sneaking in Through the Back Door
In addition to directly contributing to a Roth IRA, you can get money into one by converting money from a traditional IRA. Until 2010, you needed to have an income below $100,000 to do a conversion, but since that income cap was eliminated, anyone with a traditional IRA can convert part, if not all, of the account to a Roth.
In many cases, it's easier to qualify to get money into a traditional IRA, either through direct contributions or via rollover from a qualified employer-sponsored retirement plan. That's especially true if:
- You file your taxes as "married filing separately," yet you lived with your spouse.
- You have a modified adjusted gross income (MAGI) above $110,000 as a single filer.
- You and your spouse file jointly and together have a MAGI above $173,000.
At any of those levels, you start running into restrictions on the amount you can contribute directly to a Roth IRA -- and quickly run out of room to contribute at all. Not so for a traditional IRA, where the primary restrictions are that you have to be below age 70½ at the end of the year to contribute, and that you need to have taxable compensation of at least enough to cover the IRA contribution amount.
You may or may not be able to deduct the traditional IRA contribution, but you can still make it. And once you've got it, to go from traditional IRA to backdoor Roth IRA is as easy as contributing to the traditional IRA, then immediately converting to a Roth.
What's the Catch?
As easy as it is to do, like virtually everything related to taxes, there are strings attached. But if you follow the rules you won't get tangled in the IRS' web.
The biggest is the fact that you need to track your tax basis across all your traditional IRAs. If all your traditional IRA contributions were deductible, it's easy -- your traditional IRA tax basis is $0, and all the money you convert is taxable as ordinary income in the year you convert it.
If some or all of your contributions to your traditional IRAs were nondeductible, the math gets a bit trickier. In essence, you look at both your nondeductible basis and your total traditional IRA balance, calculate the ratio, and use that to determine how much you can convert tax-free. What's left over in your traditional IRA after your conversion remains with the same ratio of taxable basis to total value.
For instance, if you've got an $8,000 nondeductible basis and a $20,000 account balance, 60% of the amount you convert from a traditional to a Roth IRA is taxed, and the other 40% is a tax-free conversion of your taxable basis. If you convert $6,000 of that balance, $3,600 is taxable as ordinary income, and $2,400 of your conversion is nontaxable as your basis moving over. Of the $14,000 left in your traditional IRA, $5,600 is your new nondeductible basis and the rest, $8,400, remains untaxed until converted or rolled over.
You can convert some -- or all -- of your traditional IRA balance to a Roth IRA in any given year. Once converted, that money could potentially never face income taxes again. Of course, you'll want to be careful that you don't convert so much in any one given year that you can't pay the taxes on the conversion from money you've got socked away outside of the IRA. It'd be a completely wasted effort -- not only now, but for the long haul -- to be forced to liquidate your account to pay the tax on the conversion that created it.
Still, once you've got money in your Roth IRA through the conversion back door and paid any taxes on that conversion, it can stay there until you pull it out – tax-free, if you qualify -- as a retiree.