Who Should Consider a Backdoor Roth IRA?

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. As April 15 gets closer, investors might be thinking about contributing to an IRA. But for those who are over the income limits, what can they do? I'm here with Christine Benz, our director of personal finance, to look more closely at the backdoor Roth IRA.

Christine, thanks for joining me.

Christine Benz: Jeremy, it's great to be here.

Glaser: Let's talk about those income limits, about when you are making too much money to contribute directly to a Roth IRA. What are those for 2018 and 2019?

Benz: For 2018, if you are a single filer, the income limit was $135,000. If you are over that, you cannot make any type of Roth IRA contribution. If you are part of a married couple, filing jointly, again, this is for 2018, and your earnings are over $199,000, no direct Roth IRA contributions. They tick up a little bit for the 2019 tax year. If you are under $137,000, you can fund a Roth IRA directly, but if you are over that, you cannot. In 2019, for married couples filing jointly, it's $203,000 is the income limit for a direct Roth IRA contribution.

Glaser: And the limits for the deductible, traditional IRA are even lower than that?

Benz: They are. If you are shut out of a Roth IRA contribution because of these income limits, you are automatically shut out of making the traditional IRA contribution because they are lower.

Glaser: If you are above that limit, there is this backdoor Roth IRA maneuver. Can you explain what that is and what kind of makes that possible?

Benz: Right. So, the basic idea is that income limits do not apply at all to a nondeductible traditional IRA contribution. Beginning in 2010, people began to look at the fact that there were also no income limits on converting traditional IRA assets to Roth. That's really when this backdoor Roth maneuver was born and the basic idea is that if you fund that traditional nondeductible IRA and then convert it to a Roth shortly thereafter, there should, at least in theory, be no taxes due on that conversion or very limited taxes due. If you did not have any capital appreciation on the holdings within that IRA between the time you funded it and converted it, the tax bill should, in many cases, not be much at all, if anything. That's really the virtue of this backdoor Roth IRA maneuver. It lets higher income folks who are shut out of the direct contributions get money into a Roth IRA.

Glaser: How long would you need to wait before making that nondeductible contribution and doing the conversion?

Benz: That's the subject of some debate. But I think that there's starting to be a consensus view that you don't have to wait very long at all. In the past, there was some worry that, well, has the IRS really blessed this maneuver, but now I think that tax experts such as Ed Slott, for example, who focuses a lot on IRAs, thinks that you can do it pretty quickly, that you don't have to wait very long. And the beauty of that is that you can get the money working in long-term assets because you are not worried about any capital appreciation and taxes due between the time of funding and conversion.

Glaser: There are some potential pitfalls, one of them being if you have a lot of other IRA assets. Why would that be a concern?

Benz: This is the big concern with this maneuver, is for people who have, say, rollover IRA assets, traditional IRA assets that consist maybe entirely or largely of assets that have never been taxed. The issue is, when you do these conversions what comes into play is what's called the pro rata rule. The IRS looks at the tax character of all of the assets in your traditional IRAs when determining how much tax you owe on that conversion. If you have a lot of money in your IRAs, maybe in your rollover IRA that has never been taxed yet, then the tax bill due upon the conversion even thought it's a fairly small sum of money maybe higher than you anticipated.

Glaser: Is there any workaround for that?

Benz: One of the ideas that you might consider if you also have an active 401(k) plan is to roll assets into that 401(k) plan, assuming that your plan allows it. And the idea is that you are taking those rollover traditional IRA assets, if you move them into the confines of the 401(k), they don't count as a part of this pro rata rule. So, 401(k) assets don't come into play at all. That's one idea. But before you do that, you just have to make sure, A, that your plan allows it and B, that your plan is good. Because if you are rolling in substantial assets, you'd want to make sure that it is a first-class plan.

Glaser: Sounds like this is the time to maybe pay for some tax advice before making this maneuver?

Benz: It is. Check in with, if you work with a CPA around tax time, check in and ask, does this seem like something that makes sense for me. One reason why you want to be doubly sure is that what was called a recharacterization, which allowed people to essentially undo their IRA conversions, that has gone away now with the new tax laws. People need to be super-duper sure that they are not triggering any unintended tax consequences by executing this backdoor Roth IRA maneuver.

Glaser: Christine, thank you.

Benz: Thank you, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.