A Roth IRA is an individual retirement account that allows a person to set aside after-tax income up to a specified amount each year. Both earnings on the account and withdrawals after age 59 1/2 are tax free if it has been at least five years since you first opened and contributed to your Roth IRA, regardless of your age when you opened it.

A Roth IRA is an individual retirement account that allows a person to set aside after-tax income up to a specified amount each year. Both earnings on the account and withdrawals after age 59 1/2 are tax free if it has been at least five years since you first opened and contributed to your Roth IRA, regardless of your age when you opened it.

There are many clients who would like to make Roth IRA contributions, but their income exceeds the applicable income limits. Clients who earn too much money (see chart below) aren’t allowed to open Roth IRAs under current IRS rules.

This puts out of reach one of the best features of a Roth IRA, the ability to maximize tax-free growth even after age 70½, because Roth IRAs do not require minimum distributions (RMDs)1. So if you don’t need income from your Roth IRA your balance continues to grow tax-free until it passes to your heirs.

Enter the Backdoor Roth, an option for those who earn more income than the current limits to establish a Roth IRA. With a Backdoor Roth, you first make a contribution to a Traditional IRA and then convert it to a Roth IRA.

First Let’s Take a Look at the Roth IRA Limits for 2020
 20202019
Roth IRA Contribution Limit$6,000$5,500
Roth IRA Contribution Limit if 50 or over$7,000$6,500
Traditional IRA Contribution Limit$6,000$5,500
Traditional IRA Contribution Limit if 50 or over$7,000$6,500
   
Roth IRA Income Limits (for single filers)Phase-out starts at $124,000; ineligible at $139,000Phase-out starts at $120,000; ineligible at $135,000
Roth IRA Income Limits (for married filers)Phase-out starts at $196,000; ineligible at $206,000Phase-out starts at $189,000; ineligible at $199,000

What Then is a “Backdoor Roth”?

A Backdoor Roth is a conversion of Traditional IRA assets to a Roth IRA. Currently, anyone can convert money that they have put into a Traditional IRA to a Roth IRA, no matter how much income they earn. You can also roll as much money as you want from a Traditional IRA into a Roth IRA, exceeding the contribution limits on IRAs. Therefore, investors can contribute through the backdoor by making a nondeductible traditional IRA contribution and then converting to a Roth IRA. This allows you to avoid both Roth IRA income limits and Roth IRA contribution limits.

Example: Ned would like to make a Roth IRA contribution, but he is above his applicable income limit, so he is utilizing the Backdoor Roth IRA strategy. If Ned contributes $6,000 to his traditional IRA, he will have no deduction and his contribution will go in as after-tax funds. A month later, when his IRA account has risen to $6,200, Ned converts his traditional IRA to a Roth IRA. Since $6,000 of the $6,200 converted consists of after-tax dollars, only the $200 of gain will be taxable upon conversion. Thus, Ned will have paid tax on a total of $6,200, the entire balance of his Roth IRA at that point.

Looking at it from a tax standpoint, this strategy works best if you don’t have other traditional, deductible IRA assets, because if you do, part of the conversion would be subject to income tax.

Example: Jan has $114,000 in her traditional IRA, all of which is pre-tax. If Jan makes a $6,000 nondeductible (after-tax) contribution to a traditional IRA, the total IRA balance will be $120,000, $6,000 of which will be after-tax. Thus, only 5% ($6,000 / $120,000 = 5%) of her Roth IRA conversion will be tax-free. If Jan converts $6,000 from her traditional IRA to a Roth IRA after making her nondeductible contribution, just $300 would be tax free ($6,000 x 5%), while the remaining $5,700 ($6,000 – $300 = $5,700) would be taxable upon conversion.

Working with Janney

Depending on your financial needs and personal preferences, you may opt to engage in a brokerage relationship, an advisory relationship or a combination of both. Each time you open an account, we will make recommendations on which type of relationship is in your best interest based on the information you provide when you complete or update your client profile. When you engage in an advisory relationship, you will pay an asset-based fee which encompasses, among other things, a defined investment strategy, ongoing monitoring, and performance reporting. Your Financial Advisor will serve in a fiduciary capacity for your advisory accounts. For more information about Janney, please see Janney’s Relationship Summary (Form CRS) on www.janney.com/crs which details all material facts about the scope and terms of our relationship with you and any potential conflicts of interest.

By establishing a relationship with a Janney Financial Advisor, we can build a tailored financial plan and make recommendations about solutions that are aligned with your best interest and unique needs, goals, and preferences. Contact us today to discuss how we can put a plan in place designed to help you reach your financial goals.

1 Please note, RMDs from defined contribution plans under 401(a), plans described in 403(a) and 403(b), eligible (governmental) 457(b) plans, and IRAs are waived for calendar year 2020 due to the CARES Act.

The examples provided are all hypothetical and do not take into account any specific situations. The hypothetical examples are provided to help illustrate the concepts discussed throughout and do not consider the effect of fees, expenses, or other costs that will effect investing outcomes. Any actual performance results will differ from the hypothetical situations illustrated here. Please consult a professional to help you evaluate your situation before implementing any of the strategies discussed here. 

Janney Montgomery Scott LLC, its affiliates, and its employees are not in the business of providing tax, regulatory, accounting, or legal advice. These materials and any tax-related statements are not intended or written to be used, and cannot be used or relied upon, by any taxpayer for the purpose of avoiding tax penalties. Any such taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor.

About the author

Jack Cintorino

Vice President & Senior Financial Planner

Read more from Jack Cintorino

For more information about Janney, please see Janney’s Relationship Summary (Form CRS) on www.janney.com/crs which details all material facts about the scope and terms of our relationship with you and any potential conflicts of interest.

To learn about the professional background, business practices, and conduct of FINRA member firms or their financial professionals, visit FINRA’s BrokerCheck website: http://brokercheck.finra.org/