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IRA Roth IRA Taxes

The Ultimate Guide to Backdoor Roth IRA you will ever need

What is an IRA?

IRA stands for Individual Retirement Arrangement. Its an investment account for your retirement savings. However know some tax tricks ad how to access money – you can use it as a rainy day fund account, highly leveraged investment account, etc. Now with this investment account, you can invest in all those things that you can invest in a regular investment account like CDs, stocks, bonds, gold, etc. The choices will depend on your broker or custodian with whom you have opened the account.

Also rather than an investment account, you can also seld direct (its called Self Directed IRA it into different alternative investments which of course comes with higher risk and returns.

Types of IRA

There are mainly two types of IRA a Traditional IRA and Roth IRA. Then there is also SEP-IRA and SIMPLE IRAs which are for self-employed people and small business owners.

Roth IRA can only be contributed with after tax money

You can contribute before-tax money (deductible contribution) or after-tax money (non-deductible contribution) to Traditional IRA. Before-tax is good if you want to reduce your tax bill in the current year (essentially you are deferring the tax bill not getting rid of it).

Confused about what deductions means? See here how Federal income tax brackets are applied after deduction.

Annual limit applies to contribution to IRA both Roth + Traditional and changes every year.

The limit is indexed to cost of living. The extra $1,000 catch is not indexed to cost of living (i.e. it doesn’t change year to year).

Tax YearContribution Limit (Roth +Trad)
2015$5,500 (+$1,000 extra if over 50)
2016$5,500 (+$1,000 extra if over 50)
2017$5,500 (+$1,000 extra if over 50)
2018$5,500 (+$1,000 extra if over 50)
2019$6,000 (+$1,000 extra if over 50)
2020$6,000 (+$1,000 extra if over 50)
2021??

Limitations for Traditional IRA

Age: There is no age limitation on contribution go traditional IRA.

Income: you can make a before-tax contribution to a traditional IRA if you or your spouse

Note that there are no income limits of making a contribution to a traditional IRA. However, we need to understand that if we want to take a deduction for those contributions (i.e making the contribution pre-tax) there are income limits that we need to follow.

Now in this big table, you need to care about the low limits of married filing separately. Speaking from experience the penalty for excess contribution is 6% every year!

MAGI stands for Modified Adjusted Gross Income.

Tax Status2019 MAGI2020 MAGIDeduction
Single or head of household$64,000 or less$65,000 or lessFull deduction
More than $64,000 but less than $74,000More than $65,000 but less than $75,000Partial deduction
$74,000 or more$75,000 or moreNo deduction
Married filing jointly (MFJ)$103,000 or less$104,000 or lessFull deduction
More than $103,000 but less than $123,000More than $104,000 but less than $124,000Partial deduction
$123,000 or more$124,000 or moreNo deduction
MFJ (spouse covered by retirement plan at work)$193,000 or less$196,000 or lessFull deduction
More than $193,000 but less than $203,000More than $196,000 but less than $206,000Partial deduction
$203,000 or more$206,000 or moreNo deduction
Married filing separately (MFS) (you or spouse covered by retirement plan at work)Less than $10,000Less than $10,000Partial deduction
$10,000 or more$10,000 or moreNo deduction

Limitation for Roth IRA

Age: There is no age limitation on a Roth IRA.

There are income limits to contribute to Roth IRA and that’s where the Backdoor Roth IRA comes in.

Tax Status2019 MAGI2020 MAGIMax Contribution
Single, Head or MFS<122K<124K$6,000 ($7,000 if 50 or older)
122K-137K124K-139KPartial Contribution
137K+139K+No Contribution
MFJ< 193K<196K$6,000 ($7,000 if 50 or older)
193K-203K196K-206KPartial Contribution
203K+206K+No Contribution
MFS<10K<10KPartial Contribution
10K+10K+No Contribution

Withdrawals from IRAs

If you take money out of your traditional IRA you will get hit with a 10% penalty along with taxes. You do remember that a regular IRA is not a tax-free but tax-deferred account.

Also there is Required Minimum Distributions (RMD) after age 72. If you do not take RMDs you will get hit with a penalty.

RMD rules: You must start taking distributions from the IRA in the year you turn 72 – the penalty is 50% of the amount that you are supposed to withdraw that you did not. You can always take of-course more money than RMD. All the RMD money is taxed like regular income rates. This is a good resource to learn about RMD.

So you see its more like penalty if before 59.5 and penalties after 72. So you have to careful and play with the rules you are given.

There are certain cases that you can withdraw money from regular IRA without the 10% penalty if you are younger than 59.5 years of age:

  • Higher Education Expense (for yourself, spouse, children, grandchildren)- No Dollar Limits!
  • Home Purchase: Up to 10K for first home per spouse! You are considered first time home buyer if you haven’t owned a home in the last 2 years. You must use the money within 120 days of your withdrawal.
  • Birth/Adoption: Up to 5K per spouse – Also able to put this back without it counting towards your contribution limit.
  • Medical Expense for expenses greater than 7.5% of AGI
  • Health Insurance when you are unemployed – take distribution within 60 days if you get a new job.
  • SEPP (Substantial Equal payment plan) – Its a series of distribution from your IRA that is spread equally over your life expectancy. Remember once you start you can not stop these distributions. There are certain IRS rules on how you calculate these Payments.
  • Qual Reservist Distribution: If you are in the military or are called to active duty for more than 179 days
  • Death: If you die your beneficiary can take money out
  • Total and Permanent Disability: If you become disabled you can take advantage of your IRA.

Backdoor Roth Conversion Process

There are no income limits on Roth conversion.

There are no income limits on contribution to traditional IRA.

Step 1. Make sure you can contribute

First step is to determine whether you can contribute to a tradional IRA. The only restriction to this is you should ahve earned income. This could either be regular wages or self emplyment income.

Step 2: Contribute to Non-deductible Traditional IRA

So either you already have one open or you can open a traditional IRA. I would recommend Vanguard for zero fees. Also, they are excellent in making you understand the backdoor Roth IRA process. You need to call and be asked to connect to the wealth management consultant.

You can open the traditional IRA and have zero funds with Vanguard and there will be no fees.

The deadline for contributing to your 2019 tax year is April 15, 2020, but has been extended to July 15, 2020.

For the 2020 tax year you can contribute anytime between January 1, 2020-April 15, 2021.

Step 3: Convert to Roth IRA

Note that this step you can do anytime and not necessarily to do before the previous tax deadline of contribution to an IRA.

Note that do not wait to do step 3. Some people suggest waiting for a year or a month. two disadvantages: you will have to pay takes on the gains that you are converting. Although the gains wouldn’t be a lot it will still mess up things. A 5% gains on a 6000$ would be $300 and let’s say 25% tax will be $75. but it will over complicate what you are going to enter in the tax forms – so more trouble for yourself or your EA/CPA.

This waiting was very popular in 2014-2016 due to a rule called step transaction doctrine but congress classifiers this strategy saying it is already a “Present Law” in the 4 footnotes (268, 269, 276, and 277) of the conference committee report of 2018.

Footnote 268 on page 289

Booby Traps of Backdoor Conversion and how to Avoid them!

Earned Wages

You need earnings to make a contribution to a traditional IRA. If you do not earn wages or self-employment you can’t contribute to a traditional IRA.

How to avoid: Simple. Earn some money!

5-year wait

If you want to take out Roth IRA contribution you can do it anytime…but with Roth IRA conversion process you will have to wait 5 years from each conversion. So make sure you aren’t doing backdoor Roth conversion with your emergency money!

How to avoid: Track your contribution with a spreadsheet or notebook. Make sure not to take out the contribution – after all aren’t you doing all this hassle to let your money grow tax-free!

Pro-Rata Conversion due to IRA aggregation rule

Having an already existing amount in a traditional (pre-tax) IRA. This could also be a SIMPLE IRA or SEP IRA. This is a huge booby trap and you should be careful with this one. The larger the amount in your traditional IRA the worse for your backdoor Roth IRA conversion.

Look: When the conversion happens from traditional IRA to Roth IRA the IRS looks at all your traditional IRA together. This is called the IRA aggregation rule. So when a conversion happens only pro-rata portion of your non-deductible (post-tax) contribution of your IRA is converted. This example will explain the last sentence better.

Example: So let’s say you have 50K in your traditional pre-tax IRA and you added to traditional (nondeductible) IRA an extra 5K to do backdoor Roth conversion. When you convert this 5K the IRS assumes you are converting only (5K/55K) x 5K = $454.54 of post-tax money and 50K/55K * 5K = $4,545.45 of pre-tax IRA money. Now you would have to pay income tax on $4,545.45! So it’s not worth it!.

How to avoid: In the IRA aggregation rule, the employer retirement plans like 401k are not included. If you have an existing 401k which can let you roll money from your traditional pre-tax IRA that would be best. But not all 401k allow that so you will have to talk to your HR or 401k Custodian, or 401k plan sponsor. Another way to avoid is if you can open a Solo 401k because you have some self-employment income and make a small contribution to it. Now, this Solo 401k can accept transfers (rollovers) from other IRAs which will shield these IRAs from the IRA aggregation rule.

And if you can’t use the converting technique of 401K and you have a substantial amount sitting in your IRA do not do backdoor Roth IRA conversion it’s not worth it!

Warning: Most of the mistakes in the backdoor Roth IRA conversion process have been made due to this IRA aggregation rule even by financial advisors and CPAs. Either they do not know about this rule or they know but the client did not let them know they have other traditional IRA sitting around.

How to track Contributions, Transfers, Conversions, and Distributions

Do not do the mistake of just keeping the documents in a file. You need to make a table and it will make your life and your CPAs life much easier. Also there will be less mistakes in the process.

I use a simple google spreadsheet and you can use google spreadsheet, excel or just make these columns in the notebook.

This is a screenshot of the spreadsheet which will give you an idea of what columns to include. The only confusing part is a contribution made in March of a certain year could be for that year of the last year. So that’s why you need to include the date of the transaction along with which tax year it applies to.

My IRA tracking spreadsheet

References:

https://www.currentfederaltaxdevelopments.com/blog/2018/7/12/irs-indicates-agency-accepts-back-door-roth-ira-contribution-technique

https://www.fa-mag.com/news/irs-finally-says-back-door-roth-s-are-ok-39697.html

https://www.thebalance.com/when-does-a-backdoor-roth-ira-make-sense-4153803

https://www.kitces.com/blog/how-to-do-a-backdoor-roth-ira-contribution-while-avoiding-the-ira-aggregation-rule-and-the-step-transaction-doctrine/

https://www.bogleheads.org/forum/viewtopic.php?f=10&t=171621&sid=88eb3077aa26c788e1a86f9cfa31178c&start=50

https://www.financial-planning.com/news/its-not-about-timing-irs-on-backdoor-roth-conversions

https://www.forbes.com/sites/ashleaebeling/2018/01/22/congress-blesses-roth-iras-for-everyone-even-the-well-paid/#67df60997471

https://www.forbes.com/sites/ashleaebeling/2017/03/06/how-a-high-earner-couple-got-100000-into-roth-iras-via-the-backdoor/#8e880253551f

TAX Commitee Report 2018 https://www.govinfo.gov/content/pkg/CRPT-115hrpt466/pdf/CRPT-115hrpt466.pdf

https://www.whitecoatinvestor.com/forum/retirement-accounts/4553-congress-blesses-roth-iras-for-everyone-even-the-well-paid

https://www.physicianonfire.com/backdoor/
https://www.nerdwallet.com/blog/investing/backdoor-roth-ira-high-income-how-to-guide/

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