Few investors appreciate just how revolutionary the Roth IRA was when it first became available almost two decades ago. Traditionally, retirement accounts have been a method of deferring taxable income, with contributions to traditional IRAs and 401(k)s not included in current-year income, but with eventual withdrawals in retirement subject to income tax. The Roth IRA's truly tax-free treatment of retirement savings has appealed to millions of investors, but because of income limits on making contributions, many high-income savers don't have direct access to Roth IRAs. Starting in 2010, the opportunity to create a backdoor Roth IRA became available even to those who were locked out by income limits. Yet with some lawmakers seeing backdoor Roth IRAs as an abuse of the retirement vehicle, you should consider using the strategy now while it's still available. Let's take a closer look at the backdoor Roth IRA, why it's so valuable, and why some people want to make it disappear.
Sneaking into a Roth through the backdoor
Back when Roth IRAs first came into existence, high-income individuals found themselves locked out of the new retirement accounts. Even now, single filers with adjusted gross income above $131,000 aren't allowed to make Roth IRA contributions, and for joint filers, a limit of $193,000 applies. Moreover, conversions from traditional IRAs to Roth IRAs weren't allowed for those with incomes above $100,000. The combination of those factors created an insurmountable barrier to high-income savers wanting Roth access.
In 2010, though, lawmakers repealed the income limit on Roth conversions. That opened the door to Roth IRAs for high-income individuals for the first time, but it came with a hitch: Most of the time, when you convert a traditional IRA to a Roth, you have to pay income tax on the converted amount. Given how high the tax rates are for these upper-income taxpayers, paying Roth conversion tax isn't a very attractive proposition.
The backdoor Roth IRA gets around this problem by taking advantage of another tactic: the nondeductible regular IRA. Most high-income individuals aren't eligible to deduct their traditional IRA contributions because of similar income limits, but nondeductible traditional IRAs are available to anyone with earned income. Therefore, the two-step method for the backdoor Roth involves making a nondeductible IRA contribution and then converting that newly created IRA to a Roth.
If your nondeductible IRA is the only traditional IRA you own, then the Roth conversion doesn't create any tax liability. That's because the IRS recognizes the fact that you didn't get a tax deduction for your initial nondeductible IRA contribution, and so it essentially gives you credit for that contribution when considering the tax impact of the rollover.
Setting up for a backdoor Roth IRA
For many savers, though, the nondeductible IRA isn't their only traditional IRA. If you have made past IRA contributions and got tax deductions from them, then the IRS requires you to treat the conversion of your nondeductible IRA as if it came pro rata from all your IRA assets. That will subject part of the converted amount to tax.
However, there are a few things you might be able to do to rearrange your finances to use the backdoor Roth IRA strategy. Many employer 401(k) plans allow workers to roll their IRA assets into their 401(k) accounts, and money that's in a 401(k) avoids the pro-rata tax problem because of its being an employer plan rather than an individual IRA. Similarly, those who are self-employed can use self-employed 401(k) arrangements and provide for the same asset movement to set up their tax-free backdoor Roth.
Get it done
The sense of urgency about backdoor Roth IRAs comes from the fact that policymakers have increasingly seen the strategy as a form of unfair tax avoidance. The Obama administration's proposed budget for fiscal 2016 included changes that would put a halt to the backdoor Roth IRA by preventing Roth conversions involving funds from nondeductible IRAs or voluntary after-tax contributions to 401(k) plans. The budget proposal hasn't become law and likely won't, but in future, lawmakers might well target the backdoor Roth as something that unfairly benefits high-income taxpayers.
For now, though, the backdoor to a Roth IRA remains open, and high-income individuals should look closely at their financial situation to see if they can take advantage of it. Having tax-free retirement money available to you can be extremely valuable, and the backdoor Roth is the best -- and often only -- way for people subject to income limits to get the benefits of this retirement vehicle.
Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.