What is a Back Door Roth?
A Back Door Roth is a way to make a contribution to a Roth IRA even if you are above the income limits and still take advantage of the tax-deferred savings. This strategy is typically used by High Net Individuals.
How it Works
You make a contribution to a traditional IRA. Due to income limitations you will not be able to deduct this contribution. You then convert it to a Roth IRA because there are no income limitations on these conversions. Tada! You have successfully made a Roth IRA contribution even though your income would have limited a deposit directly into a Roth. Boy, that was easy!
Not so fast....Aggregation Rules
The IRS requires you to aggregate all of your IRA accounts so that when you convert your IRA into a Roth IRA, you have to do so in a pro rata fashion. For example, if you have no IRAs, you can open a non-deductible IRA, contribute $5,000, and then as soon as the money clears, rollover the $5,000 into a Roth and pay NO tax. However, if you already have an IRA with $5,000 of pre-tax contributions, open a $5,000 non-deductible IRA, and then try to rollover funds into a Roth IRA, you will have to pay tax on half of the contributions. The IRS sees $2,500 coming from your first IRA and $2,500 coming from the second IRA. Since one of the IRAs has pre-tax dollars, the conversion requires you pay taxes on it. Get it?!
"But Phil, I already have a lot of pre-tax money saved up in my IRA account so I won't get much benefit from this strategy, right?"
Wrong! We just have to do a little more work and remove your pre-tax IRA dollars from the equation. How do we do that? Find out in my next blog post....