Tax season always seems to have one special issue du jour. This year it is backdoor Roth IRAs, especially on the White Coat Investor forum. As a result, I’ve decided to devote our March newsletter to Roth IRAs and this particular post to backdoor Roth’s, the confusing loophole in the tax law that is actually a technique and not a true loophole.
Let’s start with the basics and assume you are setting up a Roth to invest for retirement, meaning we won’t discuss details like the 5-year rule and recharacterizations (which I have previously written about):
- A Roth IRA is a personal retirement account you can deposit up to $5,500/year ($6,500 if age 50+) into as long as you have at least that much earned income but don’t earn too much money (see below).
- It is a privately-owned account as opposed to an employer The two have no correlation.
- You get no tax deduction for putting money in a Roth IRA but everything that comes out is tax free, no matter what you use the money for. This gives you a fabulous incentive to grow your Roth as much as possible.
- If your spouse does not work, you can also contribute $5,500/$6,500 to a spousal Roth IRA.
- You can pass your Roth to your heirs and it is tax free to them, also.
You won’t find a bigger cheerleader for Roth IRAs than I. I think everyone should contribute to a personal Roth for both spouses and consider contributing to a work Roth IRA if offered. Maybe that should be an upcoming article.
But there’s a problem: Most of our clients don’t qualify to contribute directly to a personal Roth IRA because they make too much money. In fact, most doctors who have graduated training are barred from contributing to a Roth IRA.
That’s where the “backdoor Roth” comes in. Due to a quirk in the tax laws, the wealthiest businessperson can take advantage of the tax-free growth of a Roth IRA by contributing indirectly to a Roth IRA via a more circuitous route referred to the “backdoor Roth”. You can use this method as long as you do not have any pre-tax money in IRA accounts, including SEP, SIMPLE, rollover IRAs, or Traditional IRAs (known as TIRAs). Otherwise, you will be taxed on the conversion (I plan to cover how to get rid of these accounts in an upcoming article.)
Here’s why it works:
- The government affords taxpayers two ways to move money into a Roth IRA –
- By a direct contribution and
- By a conversion from a Traditional IRA (or “TIRA”).
A backdoor Roth takes advantage of the option to convert funds from a TIRA. Instead of one step (direct contribution), you move money into a Roth IRA in two steps and then report the transaction (step 3) as follows:
- Step 1 is to make a nondeductible contribution to a TIRA.
- Anybody with earned income can contribute to a TIRA because there are no income limitations. The only question is whether or not your contribution is deductible.
- Step 2 is to convert the balance in the TIRA to a Roth IRA
- Anybody can convert an IRA to a Roth IRA. There are no longer any income limitations.
- Step 3 is to report both step 1 and step 2 on IRS form 8606 for the applicable year(s). Form 8606 is a very important form because it records your “basis” with the IRS.
- The nondeductible contribution to the TIRA is reported on the front of form 8606, or page 1.
- The conversion to the Roth (any conversion to a Roth IRA) is reported on page 2, the back of form 8606.
A word about your “basis”: Your “basis” is the amount of your IRA contribution that you have already paid taxes on. If the IRS does not have a record of your basis, it can attempt to tax not only your original contributions, but all of the earnings on your Roth IRA since the beginning. Form 8606 is your official notification to the IRS that you have “basis” in your nondeductible TIRA (step 1) and in your Roth conversion (step 2). So, as you can see, it is very important to file those forms 8606 to record your backdoor Roth IRA basis with the IRS every year for both step 1 and step 2.
The backdoor Roth maneuver is really not a difficult process. So why is there so much confusion over it? A couple of reasons.
First of all, for timing reasons.
- Step 1, your initial TIRA contributions are made on a tax-filing year basis. That means you have from 1/1/x1 until 4/15/x2 to contribute to your nondeductible TIRA. That also means you can contribute to a TIRA for 2 years at once from 1/1/x1 through 4/15/x1. Of course that’s confusing!
- Step 2, the backdoor conversion is reported on a calendar year That means if you contribute to a nondeductible TIRA on 2/1/17 for the year 2016 and convert it on 2/2/17, you will need to report the process on tax returns for 2 years! Even though you have done this in 2 days, you have to wait a year to finish reporting it all!
Second, a lot of tax preparers don’t know anything about backdoor Roth IRAs. This is a “maneuver”, not something that is implicitly explained in black and white in the tax code. Have you ever noticed how CPAs tend to dress in black and white and wouldn’t think of signing a form in blue ink? If it’s not in our bible, we may not have listened to the sermon, know what I mean?
Every tax filing season, new clients contact us who have had to teach their CPA how to do a backdoor Roth conversion or whose tax preparer has not filed the form 8606 for the conversion. Yes, you can catch up and file those old forms 8606, but you’ll have to pay $50 for every year you file late. Yes, I think your tax preparer should pick up the tab.
What does this mean for you if you are reading this article and you are just learning about a backdoor Roth? Good news – you still have until 4/18/17 to complete step 1 of your backdoor Roth for 2016. Go ahead and contribute to your TIRA and file form 8606, even if you’ve already filed your income tax return. Open IRA accounts at your custodian of choice and contribute $5,500/$6,500 per spouse. You can even go ahead and contribute $11k per spouse and knock out your 2017 TIRA contributions, also.
- You’ll make the backdoor conversion after your contributions, but you will report them in 2017. There will be no tax effect.
- Your 2016 TIRA contributions will be reported on page 1 of form 8606 for 2016.
- Your backdoor Roth conversions will be reported on page 2 of form 8606 for 2017.
- If you’re DIY and getting a little confused about filling out form 8606, WCI has a nice tutorial with pictures.
- If you’ve already filed your 2016 income tax return, no problem. There will be no additional taxes due and all you need to do is to file an amended 1040 (called a 1040X) along with a completed form 8606 for 2016.
So why are we so big on Roth IRAs at Fox Wealth Management? Only $5,500 a year – how much difference can that make, anyway? And why would a family earning a cool half million plus greenbacks a year want to contribute $5,500 to an account that won’t even give you a tax deduction? You might be surprised. Watch Michelle’s vlog to learn just how the strategic use of Roth IRAs can make a huge impact on your retirement lifestyle.