Should you consider converting traditional IRAs to Roth accounts? With individual tax rates at a low by historical standards and a pending reversion in 2026 to the higher rates that preceded the current tax law, it could be an opportune time. Roth IRAs can potentially produce significant income tax savings over years, or even decades, and can represent a valuable investing, tax planning, retirement income planning, and estate planning strategy. In this article, we will explore the Roth IRA and a strategy known as the backdoor Roth IRA that allows individuals with high incomes to utilize a Roth IRA.
The Appeal of the Roth IRA
Funding a Roth IRA can be a potentially great way to take advantage of current lower income tax rates and establish future tax-free retirement income. Contributions are made after tax (income taxes are paid upfront) and subsequent distributions, including earnings on contributions, are income tax-free.
The owners of Roth accounts are not subject to required minimum distributions (RMDs) – unlike traditional IRAs. Money can remain in the account for as long as desired and continue to grow on a tax-deferred basis. The account owner can take out as much or as little as desired, when desired, and leave the remainder to chosen beneficiaries as an inheritance.
The availability of the stretch IRA, a popular estate planning strategy, was impacted by the passage of the 2019 SECURE Act. Many account beneficiaries (“non-eligible designated beneficiaries”) are now required to take distributions from inherited IRAs in a more compressed time frame (not exceeding 10 years). This increases the possibility that withdrawals from traditional IRAs may bump them into higher tax brackets – making an income tax-free Roth account an even more valuable asset to inherit.
Roth IRA Contribution Limits and Restrictions
Certain individuals with higher incomes (exceeding specified income thresholds and “phase out” limits) may not be permitted to contribute to a Roth IRA directly. For 2021, the specified modified adjusted gross income (MAGI) range for a single individual is $125,000 – 140,000 ($124,000 – 139,000 for 2020), and $198,000 – 208,000 for a married couple filing jointly ($196,000 – 206,000 for 2020). Within the specified range, only partial Roth IRA contributions are allowed, and no contribution can be made to a Roth IRA if the specified upper limit is reached.
For these individuals, an alternative way to establish a Roth account is through utilizing a strategy known as the “backdoor Roth IRA.”
The “Backdoor” Roth IRA
Two Step Process
Backdoor Roth IRAs are not a special type of account. They are traditional IRA accounts that have been converted to Roth IRAs. A backdoor Roth IRA involves primarily a two-step process: contribution to a traditional IRA followed by a Roth conversion.
While certain restrictions prohibit some higher income individuals from contributing to a Roth IRA, contributions to a traditional IRA may be made. For 2020 and 2021, individuals may contribute the lesser of earned income or $6,000. If age 50 or older, an individual can also make an additional catch up contribution of $1,000 each year. As of 2020 (following passage of the 2019 SECURE Act), this includes individuals over age 70 ½ who previously were not permitted to make IRA contributions. For 2020 contributions, the deadline is April 15, 2021.
The funds from a traditional IRA are transferred to a Roth IRA. The conversion may occur through one of the following means: 1) a rollover, where money received from a traditional IRA is deposited into a Roth IRA within 60 days; 2) a trustee to trustee transfer, where the traditional IRA provider sends the funds directly to the Roth IRA provider, or 3) a same trustee transfer, where funds are transferred from a traditional IRA to a Roth IRA at the same financial institution.
The income limits on Roth conversions were removed in 2010, so there are no longer income limits that restrict who can convert a traditional IRA to a Roth IRA.
Income Tax Implications
Upon conversion to a Roth account, income taxes will be incurred on any money in the traditional IRA that has not already been subject to tax. Income taxes will also be owed on any money earned between the time contributions were made to the traditional IRA and the conversion to a Roth.
Note also, funds placed in a Roth account via the backdoor Roth strategy are considered converted funds, not contributions. Consequently, the account owner must wait five years to receive penalty-free access to the funds if under the age of 59½.
The Pro Rata Rule
If an individual holds multiple traditional IRAs which include a combination of pre-tax and after-tax funding, converting to a Roth can complicate the income tax result.
The IRS “pro-rata” rule considers all of an individual’s traditional IRA accounts (not just the account being converted) when determining the taxes on conversion, and the pro rata rule is applied to an individual’s total IRA balance at year end (December 31) not at the time of conversion. Income taxes will be based on the percentage of the overall balance that has not yet been taxed. The non-taxable portion is determined by multiplying the total conversion amount by a fraction: the numerator is the value of the individual’s after tax money in all traditional IRAs, collectively; the denominator is the combined balance of all of traditional IRAs. This balance is based on the year-end value of all of the individual’s traditional IRAs plus amounts distributed from any traditional IRA during the year.
The IRS will not treat the conversion as coming solely from non-deductible or after-tax account funds. In other words, an individual can’t pick and choose which money to convert. However, it may be possible to roll pre-tax accounts into an employer sponsored plan (that will accept these funds) prior to completing the Roth conversion, in order to avoid the pro rata calculation.
Note, IRS Form 8606 is required to be filed with the account owner’s income tax return. Form 8606 reflects the pro-rata calculation, determines the tax on distributions, and reports the Roth conversion to the IRS.
The Congressional Joint Committee on Taxation, in its conference report on the Tax Cuts and Jobs Act of 2017, favorably mentioned the backdoor Roth IRA approach offering support to the backdoor Roth as a viable planning strategy1.
In 2018, the IRS released guidance that specifically addressed backdoor Roth IRA conversions, indicating their position that the backdoor Roth is allowed under current law. As a result, the strategy has gained in popularity and interest. The IRS also clarified that no waiting period is required between the IRA contribution and Roth conversion steps. However, it remains important to be sure the traditional IRA is properly established and shows it received the contribution, before converting to a Roth (clear paper trail).
Evaluating the Opportunity
April 15, 2021 is the deadline to complete a Roth IRA conversion for 2020. You may want to consider making well-timed Roth conversions over a period of several years in order to avoid incurring the income taxes all in one year. For counsel on evaluating the potential advantages of a backdoor Roth IRA in light of your particular situation, and for assistance with executing the strategy, consult with your personal tax advisor and a qualified financial planning professional.
1 The Joint Explanatory Statement of the Committee of Conference states that “Although an individual with AGI exceeding certain limits is not permitted to make a contribution directly to a Roth IRA, the individual can make a contribution to a traditional IRA and convert the traditional IRA to a Roth IRA.” (footnotes 268, 269, 276, 277).
This article is for general information purposes only and is not intended to provide legal, tax, accounting or financial advice. The information in this article, and any opinions expressed therein, do not constitute a recommendation or an offer to buy or sell any security or financial instrument. Viewers should consult with their financial, tax and/or legal professionals before making any financial or tax related decisions.