March 27 brings us the Motley Fool Answers podcast's monthly mailbag show, which Alison Southwick and Robert Brokamp dedicate to providing their best advice and insights in response to listener questions.
Our podcasting duet learned something last month: Having Ross Anderson, certified financial planner from Motley Fool Wealth Management -- a sister company of The Motley Fool -- along for the ride makes it so much easier.
In this segment, they cover a topic that gets asked about a lot by their listeners: Roth IRAs. The trio will dig into these tax-advantaged retirement accounts' limits, the legal ways around those limits, and what happens when you try to mix pre-tax and post-tax contributions in one account, among other topics.
A full transcript follows the video.
This video was recorded on March 27, 2018.
Alison Southwick: Our next question comes to us from Grace. Did the new tax law remove the ability to do a backdoor Roth IRA? As I understand it, you cannot recharacterize Roth contributions as a traditional IRA, but I'm not sure if you can still convert traditional IRA contributions to Roth?
Robert Brokamp: Here we go -- the backdoor Roth IRA. We get a lot of questions about this.
The complications around the Roth IRA all start with the fact that it's subject to income limitations. For 2018, the ability to contribute to a Roth IRA begins to phase out for singles with a modified adjusted gross income of $120,000 and it gradually fades out to where you can't contribute to a Roth IRA and that figure starts at $189,000 for couples. Once you make that much, you can't do the Roth IRA.
Now, sometimes people contribute to a Roth thinking they're fine, but then as the year goes on, they end up making more money than they thought they would. Maybe they got a bonus, or a raise, or something like that. What you can do is recharacterize the money you put into the Roth as a traditional IRA. The new law did not change that, so if you contributed to a Roth and realized you shouldn't have, you can recharacterize that.
Now, another way to get money into a Roth is to do a conversion. So, you take money that you have in a traditional IRA, you convert it to a Roth. Any of that money that is converted that is attributed to pre-tax money [in other words, contributions that you got a deduction on, and growth] will all be taxable to you in that year. But once you do the conversion, the money will grow tax-free for the rest of your life as long as you follow all the rules.
You used to be able to change your mind on a conversion, too. Do the conversion and then recharacterize that and say, "You know what? I've changed my mind." That is what has changed in the new law. If you're going to do a conversion, make sure that you're sure you want to do it and then you can pay the tax consequences of that conversion when tax time comes around.
Now, this brings us to the backdoor Roth. What some people have done [and by the way, you're still able to do it as the new tax law did not change this] is if you're not eligible to contribute to the Roth, what you do is contribute to a nondeductible traditional IRA. You don't get a deduction. It's all post-tax money. Put the money in that IRA and then convert it to a Roth. There should be little to no tax consequences because, again, you're putting in after-tax money and you're doing the conversion within a certain amount of time, so there's not a whole lot of growth that you'd be taxed on, either. That's why it's called the backdoor Roth IRA. It's pretty simple, and it's still legal.
It becomes complicated if you have other money in traditional IRAs because of something called the pro-rata rule and this is kind of complicated, so pay attention, class. Here's the deal.
Let's assume a person already has $20,000 in traditional IRA assets and it's all pre-tax money. It's all growth [in other words, stuff that would be taxed if it gets converted]. Then this person contributes $5,000 to a nondeductible traditional IRA, bringing the total to $25,000. They put in that $5,000 because they want to do the backdoor Roth. They put in $5,000 and they had $20,000, so now they have $25,000.
If they do the conversion, 80% of that will be taxable, because $20,000 of that $25,000, or 80%, was pre-tax money and growth. Even if it's in a separate account, you can't just look at one account and say, I just want to deduct this money. You have to look across all your traditional IRAs. For that reason, [for] people who already have a lot of money in traditional IRAs, the backdoor Roth is not necessarily a good thing to do. It depends on your situation.
Now, if you can take the money that you have in traditional IRAs and move it to your 401(k), some people have done that. Transfer it to your 401(k) and now, poof! Now you don't have any money in traditional IRAs. Then you do the nondeductible IRA and convert that. That's a strategy worth doing, too. But, some people have done this and moved their money into a 401(k) that stinks, and I don't think it's worth moving money into a 401(k) that stinks just so you can do the Roth conversion.
Everything I said is pretty complicated. You could still do it. The one thing that is debated among financial professionals about the backdoor Roth is how long you have to wait between the time you open the account and the time you do the conversion. Some people say you only have to wait a couple of months. Other people say you should wait at least a year. What they're afraid of is that the IRS is going to decide that this is a big loophole and they're going to come after people and say, you did this to get around the law and we're going to disallow it.
I would say wherever you're going to open the account, call them up. They've probably already done plenty of backdoor Roths. Ask them for the steps on how to do it and how long they think you should wait and follow their directions, because it can get pretty complicated, but they've done, I'm sure, hundreds of them and they can tell you what to do.
Ross Anderson: And when he talked about the nondeductible IRA, like the after-tax in the 401(k) that I was just talking about, that's because they're taxed the same way. Those are basically the same thing, is a nondeductible IRA or an after-tax 401(k) contribution. Those are very similar.
Brokamp: If you want to read about this, the guy who's considered the expert on IRAs in the U.S. is a guy named Ed Slott. He has a great website. Visit his website if you want to read a little bit more about how to do this before you make a decision.