Back Door Conversions: A Tax-Free Growth Opportunity

Many investors find the thought of using the ROTH IRA for tax-free growth as a very attractive option, but ultimately never participate. This is typically due to their income, which can phase out an investor from making a contribution to a ROTH IRA if it exceeds certain thresholds. However, investors are offered the opportunity to convert from a traditional IRA to a ROTH IRA without limitations on annual income.

Doing a conversion triggers an immediate tax liability on the pre-tax amount that is converted from the traditional IRA to the ROTH IRA. In order for this to make financial sense, there are many factors to consider. One significant concern is the investor must presume that they will be in a higher tax bracket in the future, which is most often less likely in retirement. Additionally, if they satisfy the tax liability from the funds in the account being converted rather than paying the taxes with other, post-tax, funds, they lose the tax-free growth shelter on the tax amount, which negates a reasonable portion of the intended benefit by reducing the total amount invested.

In order to make a contribution to any IRA, an investor must have earned income or have a spouse with earned income. The maximum contributions are $5,500 per individual under age 50, and $6,500 per individual over age 50 in the 2018 tax year.

The IRS rules state that for the tax year 2018, IRA contributions to a ROTH IRA are limited to the following income caps:

Single Filers can contribute the maximum if they earn up to $120,000 in adjusted gross income. Above $120,000 the contribution is reduced until you are fully phased out at $135,000 in adjusted gross income.

Joint Filers can contribute the maximum up to $189,000 in adjusted gross income. Above $189,000 the contribution is reduced for each until you are fully phased out at $199,000 in adjusted gross income.

Furthermore, the IRS places limits on contributions to traditional IRAs in order to obtain a tax deduction. Those limits are also based on income, and whether or not you and/or your spouse are actively participating in a qualified employer retirement plan.

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