Video Reports

Embed this video

Copy Code

Link to this video

Get LinkEmbedLicenseRecommend (-)Print
Bookmark and Share

By Christine Benz | 04-13-2012 09:00 AM

What You Need to Know Before Funding a Backdoor Roth

Those considering a backdoor IRA need to have a long time horizon and must carefully weigh the tax effect that other IRA assets may have on the conversation, says expert and author Ed Slott.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com.

Even if you earn too much to contribute to a Roth IRA outright, you can still get in through the backdoor. Joining me on the phone to share some tips on this strategy, is retirement expert and author Ed Slott.

Ed, thank you so much for joining me.

Ed Slott: Great to be here. Thanks.

Benz: So assuming someone is convinced that this Roth option is the better bet for them, but they can't make a direct contribution because they earn too much, one strategy that you and others have been talking about is going ahead and funding a traditional nondeductible IRA and then converting it shortly thereafter.

Let's talk about that so-called "backdoor Roth IRA" strategy. Are there any pitfalls that you should bear in mind if you're thinking that this might be the strategy that you want to undertake?

Slott: The one big pitfall about contributing for retirement is you have to realize, whatever age you are, mostly for younger people under 59 1/2 I should say, that that money is for retirement. The problems come, the pitfalls, whatever you call them, usually come in if you want to tap into that money before 59 1/2; that's a problem. So that's the first thing. You have to look at this as a long-term project--retirement.

So this backdoor Roth conversion, yes, if you make too much money, you can't contribute to a Roth. But it's unusual because conversions, which is the other type of Roth--that's not where you contribute, but where you convert an existing 401(k) or an IRA to a Roth--there is no income limit on that. I mean, if you had $1 billion in an IRA, you can convert it to a Roth, no income limits. So it's funny, for a $5,000 or $6,000 contribution, then [the IRS is] going to have income limits. They're not going to let people just put $5,000 into a Roth; $1 billion is fine, but not $5,000. So I think it's a flaw in the thinking of the law, maybe an unintended consequence or something.

So here's what you can do, though. You can contribute to an IRA, and as I said before, when I say IRA, traditional IRA, it may be deductible or not. You could always, if you have the earnings, and you're not yet 70 1/2, you can always contribute to an IRA, so that's a common misconception. People say, "Well if I make too much, I can't contribute to an IRA." No, if you make too much, you can't contribute to a Roth IRA, but there's no income limit on contributing to an IRA. So again, if you make millions of dollars, you can still contribute to an IRA. The question is, "Can I deduct that contribution?" and if you're active in a plan and you make too much money, then you can't deduct it. So you have a nondeductible IRA. But if you really wanted to do a Roth, but you couldn't do it because of the income limits, then contribute to a nondeductible traditional IRA, and then wait a few days or a week until it settles, and then convert it, because there is no income limit for conversion. So there's an easy way around it, and that's what people are doing that want to have the money ending up in a Roth IRA.

The only difference is, though, when you convert it, the dollars went into a Roth as a conversion, not as a Roth contribution, and there are slight differences.

Read Full Transcript

{1}
{1}
{2}
{0}-{1} of {2} Comments
{0}-{1} of {2} Comment
{1}
{5}
  • This post has been reported.
  • Comment removed for violation of Terms of Use ({0})
    Please create a username to comment on this article
    Username: