Key TakeawaysIf you are a single filer making a Roth IRA contribution, you can get into a direct front-door Roth IRA contribution if your income is less than $168,000; if you\u2019re part of a married couple filing jointly, it\u2019s $252,000.The backdoor Roth is a two-step process where you set up a traditional IRA that you eventually convert into a Roth.You can fund a traditional IRA and then do the conversion a week later.It\u2019s better to leave traditional IRA contributions in cash until you can get the conversion enacted.If you do invest that traditional IRA in something that has appreciation, that appreciation will be taxable until you get the funds converted.Conversions are subject to the pro rata rule. This means that from the standpoint of the taxes due on conversions on your IRAs, the IRS looks at it as one big pool of assets.If you\u2019re contributing to a company retirement plan that allows roll-ins, that can be a really nice way to remove the rollover IRA, which is the amount that would be causing you a tax headache on a backdoor conversion.<\/p>\n
Margaret Giles: Hi, I\u2019m Margaret Giles from Morningstar. Income limits apply to Roth IRA contributions, but there\u2019s a workaround for high-income earners. Joining me to discuss who should consider a backdoor Roth IRA is Christine Benz. Christine is Morningstar\u2019s director of personal finance and retirement planning. Christine, thanks for being here.<\/p>\n
Christine Benz: Great to see you, Margaret.<\/p>\n
Income Limits for Roth IRA Contributions<\/p>\n
Giles: Direct Roth IRA contributions aren\u2019t available for everyone. Before we get started on the backdoor Roth option, what are the income limits for those direct contributions through the front door?<\/p>\n
Benz: It is pretty generous, actually. If you are a single filer making a Roth IRA contribution, you can get into a direct front-door Roth IRA contribution if your income is less than $168,000. If you\u2019re part of a married couple filing jointly, it\u2019s $252,000. If you are under those thresholds, by all means, go in through the front door.<\/p>\n
Two-Step Backdoor Roth IRA Process<\/p>\n
Giles: The backdoor Roth is a two-step process.<\/p>\n
Benz: Yes.<\/p>\n
Giles: What does that entail?<\/p>\n
Benz: It\u2019s helpful to think of it as a two-step process. You\u2019re doing two things: You are funding a traditional IRA. That contribution won\u2019t be deductible, because if you earn too much to contribute to a Roth, you would also earn too much to make a deductible traditional IRA contribution. You\u2019re setting up that traditional IRA, and then at some point in the future, hopefully before too much time elapses, you are then converting that traditional IRA to a Roth. It\u2019s a two-step process.<\/p>\n
How Long Should You Wait to Do a Backdoor Roth IRA Conversion?<\/p>\n
Giles: One question that comes up is how long to wait between the two steps. Do you have any thoughts on that?<\/p>\n
Benz: I will say conventional wisdom on this has changed a little bit over the years. Initially, when this maneuver came out, it was a little bit cloak-and-dagger, that you heard, \u201cOh, you should wait, you know, a month or even a year,\u201d just to show that you really meant business in terms of setting up that traditional IRA. Now it seems like even though the maneuver hasn\u2019t been officially blessed, it seems like it has been mainstreamed, and so, people are showing a little less caution on this front. I don\u2019t think that there\u2019s a lot of reason to delay too long. In my own household, we typically would do it within a week, where you would fund that traditional IRA and then do the conversion maybe a week later. But the key reason you don\u2019t want to wait too long is that you don\u2019t want your investments to pick up much in terms of gains, because that portion of your account, that is appreciation, is going to be taxable, so you don\u2019t want to tarry too long.<\/p>\n
Should You Invest Your Traditional IRA Contributions Before Converting to Roth?<\/p>\n
Giles: That brings me to the next question that comes up, is whether to invest those funds once you\u2019ve contributed to the traditional IRA. What do you think about that?<\/p>\n
Benz: Here again, the conservative view was, yes, go ahead and get them invested in the traditional IRA, again, to look like you really meant to do this. I don\u2019t think that\u2019s necessary for the risk that I just mentioned, that if you do have the funds invested in something with some appreciation potential, short-term appreciation potential, you are going to owe taxes on that appreciation. I think that leaving the funds in the traditional IRA in cash until you can get them invested, till you can get that conversion enacted, and then you can invest in long-term assets, I think that\u2019s a better way to go.<\/p>\n
Backdoor Roth IRA Tax Implications<\/p>\n
Giles: Makes sense, especially if you\u2019re not waiting a ton of time between. Conversions to Roth IRAs usually have some tax consequences. What about this case?<\/p>\n
Benz: It depends, and so, there are two big categories where you want to be careful about taxes. One is if you did invest that traditional IRA in something and it had appreciation, until you got the funds converted, that appreciation will be taxable. But the other really big thing to keep in mind is what\u2019s called the pro rata rule, and it means from the standpoint of the taxes due on conversions on your IRAs, the IRS looks at it as one big pool of assets. You might have this smaller IRA that you\u2019ve just funded, but over here, maybe you have a big IRA rollover account that came from a former employer that consists of money that has never been taxed before. For the purpose of deciding how much to tax you on that conversion, the IRS looks at all of your accounts together and the tax complexion of all of those accounts together. Even if my new IRA is fairly small, if I have this other large IRA account, a good share of my conversion will be taxable. Get some tax advice before proceeding, and this describes a lot of households, especially given the number of jobs that people cycle through. A lot of people do have large traditional IRA balances, so just understand what the tax implications may be before proceeding with that two-step IRA.<\/p>\n
How Roll-Ins Can Mitigate Taxes on Backdoor Roth IRAs<\/p>\n
Giles: When it comes to those people who have the large traditional IRA balances, are there any workarounds if they want to get into the Roth through the back door?<\/p>\n
Benz: Yes. The main one is if you have a company retirement plan that you\u2019re contributing to, and that plan allows what are called roll-ins, allowing you to take external assets and move them into the plan, that can be a really nice way to remove the rollover IRA, the amount that would be causing you a tax headache on this backdoor conversion. It\u2019s a way to get it into the 401(k), and importantly, remove it from that pro rata calculation that I just talked about. But you do want to do your homework on the 401(k). You want to make sure that it is really good quality, that it has low costs, good-quality investment options, because you would be kind of amplifying your contributions by rolling in those assets. But that is a really nice workaround for people to consider who are in this situation.<\/p>\n
Giles: Helpful to think about Roth IRAs, getting in through the back door. Christine, thanks for taking the time.<\/p>\n
Benz: Thank you so much, Margaret.<\/p>\n
Giles: I\u2019m Margaret Giles with Morningstar. Thanks for watching.<\/p>\n
Watch 4 Simple Ways to Boost Your Safe Withdrawal Rate<\/a> for more from Christine Benz<\/a> and Margaret Giles<\/a>.<\/p>\n","protected":false},"excerpt":{"rendered":"Key TakeawaysIf you are a single filer making a Roth IRA contribution, you can get into a direct…\n","protected":false},"author":2,"featured_media":291984,"comment_status":"","ping_status":"","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[14],"tags":[138,246,111,139,69,244,245],"class_list":{"0":"post-291983","1":"post","2":"type-post","3":"status-publish","4":"format-standard","5":"has-post-thumbnail","7":"category-personal-finance","8":"tag-business","9":"tag-finance","10":"tag-new-zealand","11":"tag-newzealand","12":"tag-nz","13":"tag-personal-finance","14":"tag-personalfinance"},"_links":{"self":[{"href":"https:\/\/www.newsbeep.com\/nz\/wp-json\/wp\/v2\/posts\/291983","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.newsbeep.com\/nz\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.newsbeep.com\/nz\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.newsbeep.com\/nz\/wp-json\/wp\/v2\/users\/2"}],"replies":[{"embeddable":true,"href":"https:\/\/www.newsbeep.com\/nz\/wp-json\/wp\/v2\/comments?post=291983"}],"version-history":[{"count":0,"href":"https:\/\/www.newsbeep.com\/nz\/wp-json\/wp\/v2\/posts\/291983\/revisions"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/www.newsbeep.com\/nz\/wp-json\/wp\/v2\/media\/291984"}],"wp:attachment":[{"href":"https:\/\/www.newsbeep.com\/nz\/wp-json\/wp\/v2\/media?parent=291983"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.newsbeep.com\/nz\/wp-json\/wp\/v2\/categories?post=291983"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.newsbeep.com\/nz\/wp-json\/wp\/v2\/tags?post=291983"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}