Roth IRAs: What You Need to Know about Conversions and “Backdoor” Contributions

The unique tax treatment of Roth IRAs presents a very compelling opportunity for investors. And though income limits may prevent higher-earning individuals from making direct contributions to a Roth IRA, there are two other Roth IRA funding avenues that should be considered – IRA conversions and “backdoor” contributions.

Roth IRAs: A Refresher Course

Created by the Taxpayer Relief Act of 1997, Roth IRAs offer investors long-term, tax-free growth. Accountholders can make tax-free withdrawals once they are 59.5 years old and their accounts are at least five years old. In contrast, withdrawals from traditional IRAs are taxed as ordinary income. However, there are certain qualifications regarding direct contributions to a Roth IRA:

• For single filers in 2017, modified adjusted gross income must be less than $118,000 for a full contribution ($5,500 for people younger than 50 and $6,500 for those 50 and older), and less than $133,000 for any contribution at all.
• For married joint filers, the limits are $186,000 for a full contribution and $196,000 for any contribution.

A few other features that have made Roth IRAs popular: no required minimum distributions and the ability to make contributions after age 70.5 if you continue working, which is longer than a traditional IRA would allow and means even more opportunities to grow your wealth.

Generally speaking, Roth IRAs also offer real advantages in terms of passing wealth down to heirs. Because Roth IRA withdrawals are tax-free, beneficiaries do not have to pay income taxes on any funds left to them after the account owner has died. Thus, we often recommend that clients use other accounts for retirement income before they use Roth IRAs.

Roth IRAs also play a significant part in an efficient asset location strategy. Diversifying your investment assets among different types of accounts provides flexibility and preparation for future tax code changes. For instance, aggressive, growth-oriented investments (e.g., emerging market funds) are usually best suited for a tax-free account (like a Roth IRA). Conversely, tax-inefficient investments (e.g., bonds and real estate investment trusts) are best suited to tax-deferred accounts (like traditional IRAs), while tax-efficient assets (e.g., stock market index funds) fit well within taxable accounts.

If you want to know more about the ins-and-outs of Roth IRAs, you can find plenty of info in my previous Viewpoint on the subject.

Converting Traditional IRAs to Roth IRAs: Key Questions

Traditional IRAs, which offer only tax-deferred growth, can be converted to a Roth – something that many investors can and should do. In effect, such conversions turn before-tax dollars into after-tax dollars. There are no limits on how much you can convert. If you are considering making a standard conversion, here are a few key points to think about:

• Consider your current and future tax situation: Which bracket are you in now and which do you expect to be in in the future? This will affect your upfront payment, as the converted amount will be taxable income.
• Calculate how many years the Roth will be able to grow: Does it make up for the upfront conversion payment? Is there enough time for return on your Roth investments to be worth the conversion tax? Ideally, you would have at least five to ten years to build up a material, tax-free balance.
• Assess your ability to make the tax payment now: Can you afford to make an upfront tax payment for conversion with assets that are not part of the conversion? Should you wait for a lower tax year? Timing your conversion strategically to occur during lower income years may be the best strategy.

A Closer Look at Backdoor Contributions

Ever since the income limits on contributions to traditional individual retirement accounts (IRAs) were lifted a number of years ago, some higher-earning individuals have found a way to make contributions to Roth IRAs through a so-called “backdoor.” The well-known but often misunderstood strategy of backdoor contributions is certainly an attractive option for taking advantage of the unique benefits of Roth IRAs and minimizing your tax burden in retirement. However, there are a number of caveats to consider.

The basic “backdoor” process, which can be executed annually, involves making a contribution to a traditional IRA and, at a later time, converting some or all of the value of the traditional IRA to a Roth IRA, where it can grow tax-free. This strategy works best when:

a) you have little to no other traditional IRA assets, and
b) your contribution to the traditional IRA is non-deductible.

One last consideration: the IRS has not provided definitive guidance or specific endorsement of backdoor contributions and subsequent conversions. If the IRS were to deem the separate actions of contributing to a traditional IRA and then converting that into a Roth as a single event, it would be viewed as an ineligible Roth contribution and a penalty may apply. While this uncertainty represents a risk, many investors have been comfortable taking these steps.

Roth IRAs: Not Necessarily a No-Brainer

If you have general questions about converting a traditional IRA to a Roth IRA or are considering making a backdoor contribution, it’s best to talk with your advisor. Again, these steps make sense for many people, but others may be better off sticking with a traditional IRA. In the end, the right decision will depend upon your priorities and financial goals.