How to Do a Back-Door Roth IRA

The long-term benefits of Roth IRAs are well-known. However, if you’re inclined to salt away money in a Roth IRA instead of a traditional IRA, you may bump up against certain tax law limits. Specifically, you can’t contribute to a Roth if your annual income exceeds a specific threshold.

No worries. You still may be able to benefit from a Roth IRA by entering through the “back door.” This two-step technique is a perfectly legal maneuver that can generate tax savings in the future.

First, let’s quickly review the basics. With a traditional IRA, contributions may be partially or fully deductible, depending on your modified adjusted gross income (MAGI) and if you (or your spouse, if married) participate in an employer-sponsored retirement plan. When you make withdrawals, the portion of the distribution representing deductible contributions and earnings is taxed at ordinary income rates currently topping out at 37%. After you reach age 72 (recently increased from age 70½), you must begin “required minimum distributions" (RMDs) from the IRA.

In contrast, contributions to a Roth IRA are never tax-deductible. However, if you take "qualified distributions" from a Roth in existence at least five years, the payouts are 100% tax-free. Qualified distributions include those made after age 59½; on account of disability; or used to pay first-time homebuyer expenses (up to a lifetime limit of $10,000). And, unlike traditional IRAs, you don't have to take lifetime RMDs.

Of course, you may convert a traditional IRA to a Roth, but there’s a steep tax price to pay for this privilege. The conversion is treated as a taxable event. This can be a powerful deterrent if you’re currently taxed at a high rate.

Accordingly, you might opt to contribute directly to a Roth this year, rather than a traditional IRA. Potential problem: The ability to make annual contributions to a Roth is phased out for high-income individuals. For the 2021 tax year, the phase-out occurs between $198,000 and $208,000 of MAGI for joint filers ($125,000 and $140,000 for single filers). But here’s a—

Potential solution: Set up a traditional IRA and fund it with nondeductible contributions. (You probably don't qualify for deductible contributions anyway.) Then you can convert the funds in the traditional IRA to a Roth. Because you're not taxed on the amount representing nondeductible contributions, your tax liability is either little or zero. And you can realize the future tax benefits for your Roth just like you had made regular contributions.

There is, however, still one other obstacle in your way. You can’t designate distributions as coming from a particular IRA. Any distribution from a traditional IRA is treated as coming out on a pro rata basis from all the IRAs you own. This could result in a higher conversion tax than expected, especially if you recently rolled over a distribution from a 401(k) or other plan to a traditional IRA. To reduce the tax conversion impact, you might keep more funds in your plan account before using the back-door approach.

Does this creative tax strategy make sense for your situation? There’s no absolute “right” or “wrong” answer. Have your tax advisor crunch the numbers to make an informed decision.

Article provided by Ken Berry of Tax Practice Advisor : https://www.taxpracticeadvisor.com/individual-income-taxes/news/21238221/entering-into-a-backdoor-roth-ira