The back-door IRA is, if done properly, a “contribute and convert” strategy. There are income limits on Roth IRA contributions (currently AGI of $188,000 or greater for couples filing jointly). However, there are no adjusted gross income limits on Roth IRA conversions. So as an investor you might have income that doesn’t qualify for direct Roth contributions but since there are no income limits on a traditional IRA you can still contribute to a non-deductible traditional IRA and then convert it to a Roth IRA. With this back-door Roth feature, what investors could do is contribute toward a traditional IRA and then quickly, convert it to a Roth IRA. This two-step process allows high-income earners to participate in the benefits of a Roth IRA (assuming this is a strategy the investor is interested in pursuing).
Two important considerations:
First, do the conversion quickly after the original contribution is made so that the account doesn’t accumulate any earnings, if it does, the rollover triggers income tax only on the appreciation of the after-tax contributions, which would likely be negligible. Repeat the technique each year using the same traditional IRA and Roth IRA.
Second, if you have other traditional IRAs that will not be converted, the IRS requires you to aggregate all of those IRAs, so this could potentially be a taxable event. This is due to the "pro-rata" rule, requiring investors with pre-tax contributions in a traditional IRA as well as nondeductible IRA contributions to divide the value of their nondeductible contributions by their aggregate IRA assets to determine what percentage can be converted tax-free. Which is why this technique works best for younger professionals with high incomes that don't already have a large amount of savings in a traditional IRA’s.
One advantage of this strategy is drawing from a Roth IRA will help reduce the income taxes owed in retirement when you begin taking distributions. When the conditions are right, this is a practical solution for investors who want to maximize their retirement earnings and retirement cash-flow.
As always, remember that all investing is subject to risk so it is wise to consult an accredited professional before making investment decisions.
CBlakely CFP® 01/2014