Saving for retirement can be a concern for anyone, especially as the traditional means, such as pension programs have been starting to disappear from many companies. One of the most common alternatives to the old system is contributions to an Individual Retirement Account, or IRA for short. There are multiple different types of retirement accounts, with the main difference being whether contributions or distributions are taxed. The Roth IRA is often seen as the preferred savings method, as it allows for tax-free distributions once you retire, but it can also be limited by current tax law. This is where it becomes important to understand the back-door method for contributing to a Roth IRA.
The two main barriers in contributing to a Roth IRA are the maximum contribution and maximum income figures. In 2018, a maximum of $5,500 could be contributed by someone younger than 50 years old, and $6,500 for someone older. Additionally, Roth IRA contributions were not allowed for single-filers making greater than $135,000 annually or joint-filers exceeding $199,000. In order to maneuver past these restrictions, you can make contributions to a nondeductible IRA, which are not limited, and then convert these funds to a Roth IRA. By converting from a nondeductible IRA, where only earnings from interest are taxed during distribution, rather than a traditional IRA, where the entire distribution is taxed, you are able to reduce the tax burden felt during the conversion of the account.
It is important to note that the back-door method for Roth IRA contributions are useful to many but may not always be the best option. The most common issue you may face is if the majority of your IRA contributions have been to traditional IRAs, and therefore not yet taxed. If this is the case, any conversions will be taxed based on the proportion of all your IRA funds that have not been taxed, which can lead to a higher than expected conversion tax. This is a common occurrence for people who have recently rolled over a 401(k) or similar plan. In order to make the best decision for yourself, you should make sure to understand the tax status of all your retirement savings accounts.