Is Backdoor Roth IRA legal

Is Backdoor Roth IRA legal

Is Backdoor Roth IRA legal? Backdoor Roth IRA is perfectly legal provided certain requirements are observed. Current law allows huge backdoor contributions to a Roth IRA using tax-deferred savings from a 401(k) plan.

In short, Backdoor Roth IRA is a legal way to go around IRS MAGI restricts high earners from participating in Roth IRA.

However, in pending legislation, lawmakers have proposed new rules to limit IRA accounts for the wealthy. This is as part of a broader restructuring of the tax code tied to the Democrats Build Back Better legislation.

This will effectively close “backdoor Roth” tax loopholes for the rich and includes;

• Ensuring RMDs are tied to wealth as opposed to age. Wealthy savers with more than $10 million in IRA will be forced to draw down their accounts every year.
• It cuts further contributions to these IRA accounts that are in excess of $10 million.
• Prevent any after-tax contributions in 401(k) and IRAs from conversion to Roth savings. This will apply to all income levels starting Dec. 31, 2021
• A cap on conversions to 2022 pre-tax contributions.

Backdoor Roth Basis

This is made possible due to the following factors;

• 401(k) plans and other traditional IRA’s have higher annual savings limits or no limits at all.
• Again, there are income limits on contribution limits to fund or open Roth IRAs (if MAGI exceeds $140,000 in 2021).
• Lastly, Current law allows account holders to convert a traditional IRA (which doesn’t have an income limit) and 401(k)’s to a Roth account. This presents a tax-planning opportunity for high earners who ordinarily would not have access to a Roth IRA.

The backdoor Roth IRA is in existence only because of IRS income limits that restrict wealthier account holders from contributing to them.

How does Backdoor Roth IRA work

A “backdoor Roth IRA” is not an account, rather a description of strategies. This involves the following steps;

• Make contributions to a traditional IRA
• Leave the money in cash-as any gains complicates the paperwork down the line
• Convert the nondeductible contributions from the traditional plan to a Roth IRA,
• Pay ensuing taxes and it’s good to go. Remember, only post-tax dollars (taxable event but tax is zero) should go to Roth IRA else you will need to pay taxes on pre-tax contributions.

When to do Backdoor Roth IRA

Backdoor Roth IRA is the best option when;

• You have a retirement plan through your employer
• When you earn or will soon hit a MAGI of over $208,000. This incomes level bars you from making direct Roth IRA contributions nor enjoying deductions on your traditional IRA contributions.
• In need of simple estate planning. Beneficiaries are saved from the hustle of a probate process hence less costly, minimum hassle, and private. Its tax effective as the heirs can stretch the inheritance.

Backdoor Roth IRA is not the best option if;

• If you plan to pay off taxes due from the withdrawal itself. In this instance, not only are you are trading off future investment growth but risking the 10% early withdrawal penalty (if less than 59½ years).
• You might be in need of savings in the next 5 years. The savings must observe the 5-year limit else 10% early withdrawal penalty applies.
• The conversion won’t push you into a higher income tax bracket. Always convert just enough to keep in a favorable tax bracket.

Can I do Backdoor Roth in 2022 | Did Backdoor Roth get eliminated | Backdoor Roth eliminated | Changes to Backdoor Roth

Backdoor Roth IRA has been a trending item for most of 2021 due to President Biden’s “Build Back Better” legislation (provisions in this bill will ultimately eliminate the backdoor Roth IRA loophole). The process has not been finalized and current laws are still in use.

However, this presents a good time for wealthy savers to evaluate their current Roth IRA strategy and prepare contingent strategies for mitigating potential losses.

Can I do a Backdoor Roth if I have a Simple IRA | Traditional IRA rollover to Roth | Backdoor Roth and 401k

There is no limit on contributions to pre-tax IRAs. However, wealthy contributors can’t deduct this contribution from their taxable income, as lower earners do.

High-income earners can sidestep the income limits on Roth IRA via a “backdoor” contribution. Investors who contribute to a traditional, tax-deferred IRA can convert this savings to Roth; pay tax upon conversion (if any), but shield earnings from future tax and RMDs

How much can I contribute to Backdoor Roth IRA | Limit to Backdoor Roth | Backdoor Roth contribution limit

 Roth backdoor contribution limit depends on the tax-deferred plan being used, assuming the contributions will be converted in the same tax year;

• If using a 401(k), 403(b), most 457 plans, and the federal government’s Thrift Savings plans, the annual contribution limit is $20,500 for the tax year 2022(for $19,500 in 2021)
• If using Traditional IRA the maximum contribution for 2022 is $6,000 (under 50 years). Workers aged 50 and above qualify for a catch-up contribution of $1,000 per year hence maximum IRA contribution of $7,000.

The other option is to do a Mega Backdoor Roth IRA. Some employment plans have higher limits and may potentially allow you to stuff as much as $65K per year into a Roth IRA.

Backdoor Roth Withdrawal Rules

The following rules must be observed to avoid penalties:

 Types of transfers

This should be any of the following:

• An IRA rollover, which must be deposited into the Roth IRA within 60 days,
• IRA trustee sends money directly to your Roth IRA trustee, or
• Same trustee transfer, where both accounts are domiciled within the same institution.

The pro-rata rule

When determining taxes accruing on backdoor Roth IRA conversion, IRS regards all your current IRA accounts as one entity (aggregation rule) i.e. IRS is looking at all of your traditional IRA accounts combined (but not 401(k)s, 403(b)s, 457(b)s, Roth IRAs, or inherited IRAs).

The pro-rata rule taxes partially or fully converted Roth accounts in proportion to the fraction of after-tax vs. before-tax contributions. The percentage of funds yet to be taxed, will be taxed at a pro-rata rate regardless of whether you are transferring a single account or all accounts.

For example, let’s say your fund has 80% pre-tax money and 30% after-tax money. When doing the conversion, IRS won’t allow you to take out only the after-tax money (cream in the coffee rule). The 80% will be taxed as well (you are not in a position to convert after-tax money only). Please also remember that the pro-rata rule is applied to the total IRA balance at year-end, not the time of conversion.

To skirt around the pro-rata rule that account holder can;

• Roll all deductible contributions and pretax earnings from an IRA into the employer’s 401(k), ensure all that’s left is the non-deductible contributions. Then can be converted tax-free to a Roth.
• Make nondeductible contributions to a non-working spouse traditional IRA and they convert the contributions to a Roth account tax-free.

5-Year Rule

The Trio of 5-Year Rules

First 5 year rule (General rule)

Generally, IRS doesn’t allow withdrawal of Roth IRA earnings without payment of taxes (and often penalties) unless your first contribution to a Roth account is compliant with the 5-year rule (The first contribution was made at least five years ago).

Second 5-year rule (Conversion year rule)

IRS will issue a 10% early distribution penalty for early access to funds converted to a Roth IRA before a full five years after the date of the conversion.  However, IRS has a few exceptions to this requirement;

·         You’re 59 ½ or older or

·         You become disabled or die.

Third 5-year rule (Inherited rule)

The surviving spouse can inherit a Roth IRA and withdraw any funds tax-free, provided the account has been in existence for at least 5 years else 10% early withdrawal penalty is applicable.

How to report a Backdoor Roth on Form 8606

IRS requires the use of Form 8606 to report funds converted from a traditional, SEP, or SIMPLE IRA to a Roth IRA. Please take note that;

• Failure to file Form 8607 attracts a penalty of $50.
• Each spouse needs their own Form 8606
• Ensure lines 2, 14, 15c, and 18 are zero or close to zero.

Form 8606 should be filled as follows;

Bottom line

 Take note that conversion of the nondeductible contributions of a Traditional IRA is still a taxable event only that the tax charge will be zero.

In as much as the conversion looks simple, be wary of all tax and legal implications specifically pro-rata rules. Consider engaging a Certified Financial Professional with a background in retirement planning.