My last post discussed all the legal jargon that our wonderful Congressional leaders stuck into the tax code to make calculating how much you can actually contribute to a Roth IRA as difficult as possible. To summarize, if you’re making somewhere between $110k and $200k a year, you may not be able to contribute directly to a Roth IRA.
The Word of the Day for our Roth IRA is “directly.”
Our wonderful media enjoys tossing around the word loophole like a bunch of kids playing with a ball of slime, both confused and fascinated by what they’re holding in their hands. As a general rule of thumb, if the media says “loophole,” what they really mean is a totally intentional deduction that a previous group of politicians passed that our current group of politicians doesn’t like.
This Roth IRA back door, however, I think is actually a loophole. Meaning some Congressional aide didn’t do his or her homework before signing off on it.
Okay, so now that I’ve primed the pump, are you ready for this super secret tax loophole?
Step .5 (Optional, if available): Roll over your traditional IRA to a 401(k) plan
Step 1: Make a nondeductible contribution to a traditional IRA.
Step 2: Roll over the Traditional IRA into a Roth IRA
That’s it. You’re done.
I should probably give a little more explanation for those weird people who want to know how the gears churn.
Let’s start with Step 1, since we’ll need some background before getting into Step .5.
Both the Traditional IRA and Roth IRA limit how much you can contribute ($5,500 if you’re under 50, $6,500 if you’re over 50). The limit is reduced based on how much money you make as discussed in the previous post. However, if you reach that limitation with a Traditional IRA, you can still make what’s called a Designated Nondeductible Contribution (take a look at Code Sec. 404(o) for those Codeheads out there). This allows you to contribute to a Traditional IRA, just without the benefit of receiving a deduction on your tax return.
Quick, what’s the benefit of a Traditional IRA?
Answer: You get a deduction now, but have to pay taxes on the gains later. So if you make a Nondeductible Contribution, it makes the Traditional IRA lose it’s primary tax benefit.
That, however, leads us to Step 2, which is rolling that Traditional IRA into a Roth IRA.
Quick (#2), what’s the benefit of a Roth IRA?
Answer #2: You pay taxes now, but you don’t have to pay taxes on the gains in the future.
Nondeductible Contributions to a Traditional IRA means taxes now and on gains in the future. However, by rolling our Nondeductible Contribution into a Roth IRA, we get the benefit of the Roth IRA without being subject to the Roth IRA income limitation.
So what’s up with Step .5?
The back door Roth IRA method has one drawback: Traditional IRAs are treated as a single contract. Therefore, the current year Nondeductible Contribution will be grouped with your previous deductible contributions, and will have to go through some formula to determine which amounts are actually rolled over into your Roth IRA. So you could be paying taxes on money you really didn’t want to move into a Roth IRA.
A potential way to get around this is to roll your Traditional IRA money into a 401(k), which operate on more or less the same tax rules once it’s all contributed. Then the only amount you’re rolling from your Traditional IRA into a Roth IRA will be those Nondeductible Contributions that you really wanted in the Roth IRA in the first place.
The rules for rolling a Traditional IRA into a 401(k) is a whole different can of worms. That, my friends, will be discussed at another time.