The Roth IRA is the best way to take advantage of current low income tax rates. With the tax reform efforts that became effective in 2018 cutting rates to their lowest levels in years, investors got an opportunity to forego less valuable current tax breaks in exchange for the long-term tax benefits that Roth IRAs offer.
However, not everyone is allowed to contribute to a Roth IRA directly. For them, the only way into a Roth is through the back door -- with a strategy appropriately known as the backdoor Roth. Below, we'll give you all the details on how you can use this tax-saving strategy, along with an explanation of why now's the perfect time to get started.
The problem with Roth IRAs
In general, if you have earned income from work, then you can make an IRA contribution. For 2020, you can contribute up to $6,000, with those 50 or older, getting to add an extra $1,000.
However, with Roth IRAs, your income has to be below certain limits in order to contribute money. Those limits depend on your tax filing status. If your income is above a defined upper limit, then you can't contribute to a Roth IRA in 2020 at all. Within a range just below that upper limit, only partial Roth IRA contributions are allowed.
| For This Filing Status: | The Income Limit in 2020 Is |
|---|---|
| Single, head of household, or married filing separately IF you didn't live with your spouse during the year | $124,000 to $139,000 |
| Married filing jointly or qualifying widow or widower | $196,000 to $206,000 |
| Married filing separately IF you lived with your spouse at any point during the year | $0 to $10,000 |
Data source: IRS.
So if your income's above the limit, you're out of luck for making a direct Roth contribution. But you can still make a contribution to a traditional IRA, and that's where the backdoor Roth strategy comes in.
The basics of the backdoor Roth
Even though there are income limits on Roth contributions, there aren't any limits on Roth conversions. You can earn as much as you want and still convert a traditional IRA to a Roth.
As a result, there are a couple of ways you can get money into a Roth using the backdoor Roth strategy:
- You can make a deductible traditional IRA contribution and then convert that IRA to a Roth IRA.
- You can make a nondeductible traditional IRA contribution and then do a Roth conversion.
The first method would generally be the easiest. You'd get a deduction on the initial contribution, and then you'd have taxable income when you convert that would offset the deduction and leave you in the same place you would've been if you'd been able to contribute to a Roth IRA in the first place. But there's a catch: Many people are subject to income limits on deducting traditional IRA contributions.
For them, the second method is available. If the nondeductible IRA is the only traditional IRA you own, then you can convert it to a Roth without having to pay tax. The reason: you contributed after-tax dollars to the nondeductible traditional IRA, so you don't have to pay tax again on that after-tax money when you convert.
Unfortunately, if you have additional traditional IRA assets, then there's another problem. The IRS won't let you treat the conversion as coming solely from the nondeductible IRA. Instead, you'll have to include a portion of the conversion in your taxable income, based on the pro rata value of your nondeductible and other traditional IRA assets. That's generally not desirable, so if you have extensive retirement assets in deductible traditional IRAs, you should think twice before trying to do a backdoor Roth.
Put low tax rates on your side
Despite the potential pitfalls, the backdoor Roth strategy can be valuable in getting money into a tax-free account. Moreover, with every possibility that tax rates will go higher from here, getting as much money into Roth IRAs now could pay off even more in the long run. Whether you already have Roth IRAs among your investments or are just now considering them, the time is ripe to look more closely to see how Roth IRAs can help you save for retirement more effectively.
