A Backdoor Roth IRA (also referred to ask a Roth IRA conversion or re-characterization) is not a type of retirement account but a tax strategy for high-income taxpayers to fund a Roth. Taxpayers that have a Modified Adjusted Gross Income (MAGI) greater than the threshold set by the IRS are unable to contribute to a Roth IRA. However, contributions to traditional IRAs are not subject to MAGI limitations. In 2021, direct Roth IRA contributions are not allowed for single filers with a MAGI of $140K or more, or married couples filing jointly whose MAGI exceeds $208K. A Roth IRA conversion is a transfer of retirement assets from a Traditional, SEP, or Simple IRA into a Roth IRA which allows taxpayers to circumvent these limitations. Once received, the distributed funds must roll over into the new account within 60 days. This strategy allows taxpayers to fund a Roth even if their income exceeds the threshold allowed.
One tax benefit of a Roth IRA is that the assets held do not incur tax as they grow. Therefore, a Backdoor Roth IRA conversion prevents your nondeductible contributions from accumulating taxable investment gains. However, if during the conversion process you have not paid tax on the money in your traditional IRA, then the taxes must be paid on those funds at the time of the conversion. Additional benefits to a Roth IRA include tax-free withdrawals, no early withdrawal penalty, no Required Minimum Distributions (RMDs), and tax-free inheritance to heirs.
The first step in converting to a Roth IRA is to contribute to a non-deductible IRA. Contributions to a nondeductible IRA are not limited by a MAGI (Modified Adjusted Gross Income) threshold, however, the annual IRA contribution limits do apply. Once the IRA is funded the taxpayer can then convert the IRA to a Roth. Funds can be moved to an existing Roth account or the taxpayer can open a new Roth account. The conversion is then reported to the IRS on Form 8606. Once the conversion is complete the money in the Roth IRA becomes subject to the Roth IRA distribution rules.
Converting a nondeductible IRA to a Roth IRA is not complicated; however, the tax issues associated with this conversion can be. It is important to weigh the pros and cons with a financial advisor first to decide if a Backdoor Roth IRA is right for you.