What Is A Back Door IRA Contribution?

October 2, 2021

What Is A Back Door IRA Contribution?

What Is A Back Door IRA Contribution?

A back door IRA contribution is a way for an investor to make a contribution to an Individual Retirement Arrangement (IRA), such as a Traditional or Roth IRA when the individual does not meet the ordinary income limits set by the Internal Revenue Service (IRS).

A back door IRA can be used in cases where you don't have enough earned income to contribute directly to a tax-deductible traditional IRA and/or you can't contribute directly to a Roth IRA. This type of arrangement is sometimes referred to as making an indirect or non-taxable contribution.

How Back Door Contributions Work

To do so requires using what's known as a "backdoor" strategy which involves making contributions through investments rather than direct contributions to IRA plans. It is possible to contribute directly to a Roth IRA, but income limits apply.

A back door contribution allows you to contribute money into your IRA, which you can then later take out tax-free since the withdrawal will be considered an early distribution; these are reported on IRS Form 5329.

Funds are withdrawn from an IRA before age 59 1/2 may be subject to additional taxes and penalties (except for certain exceptions). See IRS Topic 554 Learning about distributions (early withdrawals) for more information.

If you have both types of IRAs, it's possible that if one isn't large enough at first, the other might become too large over time as you incur further taxable income.

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Backdoor IRA Contributions Requirements

The contribution limits for Traditional and Roth IRAs are the same. Also, there is no time limit on when backdoor IRA contributions must be made. This allows investors to contribute additional money into an existing IRA at a later date if they don't have enough self-employment income or other qualifying income to qualify for another non-deductible contribution.

The minimum annual contribution limit for both deductible and nondeductible traditional IRA contributions is $6,000 ($7,000 for individuals who are age 50 or older). As of 2021, the maximum contribution allowed in both cases is the smaller of 100% of earned income or $58,000. A participant's eligible compensation during the year may be considered as earned income for purposes of making a non-deductible contribution.

Since this method doesn't involve direct traditional IRA contributions, it also means that modified Adjusted Gross Income (AGI) can be used to determine eligibility because backdoor Roth IRA contributions aren't reported as taxable income.

Contribution deadlines: Contributions must be postmarked by April 15th following the calendar year in which you turn 70 1/2.. For example, if you reach that age on February 29th, 2021, your deadline will be April 15th, 2022.

Roth IRA Conversion Process

Once you have the money in the account (in this case an IRA), it can then be converted into a Roth IRA if your income is within the limits and you meet other requirements.

The total amount must then follow all the normal distribution rules for both traditional and Roth IRAs; see IRS Publication 590-B Distributions from Individual Retirement Arrangements (IRAs). The big difference with conversion is that once it has been completed, any future earnings or gains on those assets would be tax-free at the federal level. Although conversions are reported as taxable income, any basis - which represents nondeductible contributions - would not be taxed.

If your money is in an IRA and you've already paid the tax, there's no credit for future taxation since this would be double taxation. You must then decide if converting that money into a Roth IRA will give you a better outcome than just paying the tax and keeping all of it in deductible IRAs.

Of course, in most cases, taxable income determines eligibility for financial aid so the Roth IRA conversion might cause some negative tax implications.

Additionally, once the conversion process has been completed there is no going back. That means you cannot reverse it or transfer it to another account within 60 days of completing the transaction.

Converting Traditional Retirement Plans to Roth IRA Contributions

The same rules also apply to transfer from one type of retirement plan to another. Employees who leave their jobs can roll their 401(k) accounts into IRAs, including traditional or Roth IRAs. This also includes old 403(b), 457, and thrift savings plans that have moved to the IRS, but there are limitations depending on your age.

For example, if you are under age 59 ½ at the time of conversion, you will be subject to a 10% early withdrawal penalty unless you meet certain criteria defined by the IRS. Also, note that distributions from an IRA are considered taxable income in the year they are withdrawn even if they consist of nondeductible contributions.

However, if this is one of several IRAs that has been established over your lifetime, then any distributions represent a pro-rata share of nondeductible contributions and earnings.

This means you can withdraw your basis (nondeductible contributions) from all of the IRAs with minimal or no tax consequences directly from each IRA account.

Roth IRA Conversion Requirements

The basic requirements for Roth IRA conversions are: You must be under age 70 ½ when making a traditional retirement plan to Roth IRA rollover contributions.

If you're over age 70 ½, you cannot make direct rollovers/conversions but you can do a recharacterization (see below). Your modified adjusted gross income (MAGI), is within allowable limits:

If you file taxes as a single person, your Modified Adjusted Gross Income (MAGI) must be under $139,000 for the tax year 2020 and under $140,000 for the tax year 2021 to contribute to a Roth IRA, and if you're married and file jointly, your MAGI must be under $206,000 for the tax year 2020 and 208,000 for the tax year 2021.

The maximum total annual contribution for all your IRAs combined is:

  • $6,000 if you're under age 50
  • $7,000 if you're age 50 or older*

Source For Above: https://www.schwab.com/ira/roth-ira/contribution-limits

There are no income restrictions for conversions from a traditional IRA to Roth IRA when the taxpayer has ceased working. The pro-rata rule still applies in this case. It means that if only one spouse is over age 70 ½ at the time of conversion, their low tax bracket might make it beneficial for them to do a recharacterization instead.

Recharacterizing Contributions and Conversions

If you want to undo your Roth conversion because your original plan was better after all, then you can opt for recharacterization. Recharacterizations are available until October 15th of the year following the initial contribution/conversion deadline. Similar to rollover rules, amounts cannot be recharacterized into an account where they have already been converted to Roth IRA.

Conversions must be reported on your federal income tax return for the year in which they are made. You will have to pay taxes due on the entire amount of conversion, but you can elect to spread the income taxes due over two years through annualizing. This way you'll only need to come up with half of what you owe for that tax payment when filing your return. Should there be any investment gains in the account since it was opened, then they would have to be included as part of taxable income as well even if those gains were not distributed.

Rollovers and Transfers

If a traditional retirement plan is rolled or transferred into a qualified IRA account, then future earnings and gains on those contributions are tax-deferred (i.e., not taxed until withdrawal). Roth IRA conversions, on the other hand, result in taxable income equal to the full amount of contributions and earnings.

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Why convert Traditional Retirement Plan into a Roth IRA?

Conditions that might motivate you to convert your traditional retirement plan into a Roth IRA include: You want to take advantage of future appreciation within the account. Since there are no required minimum distribution rules for the Roth IRA once it is opened, you can leave assets in place until they appreciate enough to cover living expenses during retirement or additional needs beyond that time period. Taxes are low now so conversion makes sense since you will likely be in higher tax brackets when you begin withdrawing funds from the account beginning at age 59 1/2. By converting at a relatively low tax rate, you will be able to pay the income taxes due on your conversion with money that would otherwise be used for living expenses or reinvested elsewhere. The rules allow you to withdraw any contributions (but not earnings) from Roth IRA accounts tax and penalty-free anytime before age 591/2 should that become necessary.

If you plan to convert all or part of your traditional retirement plan into Roth IRA, then it is recommended that you consult with a professional financial advisor before proceeding so they can help determine if such a conversion makes sense given your personal situation and goals. Bear in mind: The longer the time horizon until distributions begin, the greater opportunity there is for earnings and appreciation within an account to offset conversion taxes. It is our job as tax consultants to evaluate the various factors for each client's specific situation before recommending the best course of action.

Last but not least, I'd like to advise you that it may be possible for you to reduce or completely eliminate the tax bill associated with this kind of conversion if you are able to take advantage of available tax credits, deductions, and exclusions available under IRS code.

Disclaimer: This is not investment advice, just commentary.  Always do your own research and consult with a licensed financial advisor when making any type of investment.

About the author 

Jenna Lofton, the founder of StockHitter.com, has been actively trading stocks and investing for nearly 11 years.

She holds an MBA in Finance, and another in Business Administration, and lives in Staten Island, NY.

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