Because you may take tax-free withdrawals from a Roth individual retirement account (IRA) when you retire, it's a popular retirement savings strategy. Unlike other types of plans, required minimum distributions (RMDs) are not required during the account owner's lifetime. Due to Roth IRA income limits, high-income individuals may be denied the opportunity to contribute to these accounts. They can, however, indirectly redirect money into a Roth IRA by making nondeductible IRA contributions to a traditional IRA first.
IRA Contributions: Deductible vs. Nondeductible
Contributions to a traditional IRA that aren't tax deductible are subject to the same contribution limits as those that are. In 2021 and 2022, you can donate up to $6,000 tax-free, or $7,000 if you're 50 or older. The distinction is in the way the contribution is taxed. Traditional IRA contributions are made with pre-tax dollars. You can deduct them from your taxes at the time of purchase. You don't have to pay taxes on that money until you take it out. After-tax dollars are used for nondeductible IRA contributions. You can't claim them as a tax deduction. When you remove the funds, they are not taxed. Contributions to a Roth IRA are also made with after-tax money. You won't get a tax break for them, but you will be able to take eligible distributions from them without paying additional income taxes. Nondeductible IRA contributions must be reported on Form 8606. These serve as your "fundamentals" in the asset pool. A typical IRA allows you to make both deductible and nondeductible contributions, but only your base is tax-free. The portion of the distribution that is deductible is still taxable. You can keep all of your nondeductible contributions in a separate account. This will make it easy to keep track of them and report on them. Roth IRA Income Limits For people whose adjusted gross incomes (AGIs) are too high to contribute to a Roth IRA, nondeductible IRAs can be advantageous. If you're single, for example, your ability to contribute to a Roth begins to phase out at an income level of $125,000 in 2021. In 2022, the phase-out ceiling will rise to $129,000. For singles with an AGI of $140,000 or over in 2021 ($144,000 in 2022), Roth contributions aren't allowed at all. If you're one of these investors, you might want to consider making nondeductible contributions to your traditional IRA. After that, you can convert them to Roth IRA holdings. A "backdoor Roth IRA" technique involves converting nondeductible IRA money to a Roth. Contributions that are not tax deductible can be converted to a Roth IRA Each year, you can contribute to a nondeductible IRA and then convert it to a Roth IRA by utilizing the backdoor strategy. Any converted amount that exceeds your basis at the moment of conversion will be taxed. 2. If you have other IRA accounts, your basis must be computed using a pro-rata, or proportionate, formula. Consider the following scenario: you have $12,000 in a regular IRA. You contribute $6,000 to a separate IRA account that is not tax deductible. You now have $18,000 in two separate IRAs. The nondeductible portion is one-third of the total, while the deductible portion is the other two-thirds. You can't convert just the portion of your IRA that isn't tax deductible. The IRS calculates your basis proportionally based on all of your IRA accounts combined. If you convert merely $6,000, one-third of the converted amount (about $2,000) would be considered the basis, and the remaining two-thirds (approximately $4,000) would be deemed taxable income in the year of the conversion. If your investments perform well and grow tax-free for many years inside your Roth IRA, the cost of converting a Roth would be a tiny amount to pay. The Pro-Rata Basis Rule should be avoided If you have all of your other retirement funds in a 401(k) plan, the pro-rata basis rule does not apply. You could then contribute to an IRA that is not tax deductible each year. If you immediately converted it to a Roth, the full amount of the conversion would be the basis. Let's imagine you have $300,000 in your 401(k) plan and nothing in your IRA. You can make a nondeductible contribution to the IRA and then convert it to a Roth. Because it's all basis, the converted amount isn't taxable income. It was paid for with after-tax funds. Traditional IRA holdings can also be rolled back into an employer plan like a 401(k), leaving only nondeductible IRA balances outside the plan. You could therefore apply the backdoor Roth-conversion technique without having to account for the pro-rata basis in the future. To avoid paying taxes when converting your regular IRA to a Roth IRA, keep only nondeductible contributions in your traditional IRA. Reporting Taxes The IRS requires year-end account balances for the year in which you file Form 8606 and your tax return. To employ the conversion technique for that year, you'd have to roll conventional IRA contributions into a 401(k) plan before the end of the year. If you have no funds left at the end of the year, you can convert only the balance of your nondeductible IRA contributions to a Roth using the backdoor strategy. If money in traditional IRAs, SEPs, or SIMPLE IRAs was rolled over into a qualifying plan, it would be included. Changes in tax laws in the future may alter this strategy. Common IRA Errors The most common nondeductible IRA mistake is failing to include Form 8606 with your tax return. If you've made nondeductible IRA contributions but haven't reported your basis, you can report it in arrears. Another typical blunder is believing that you can only convert nondeductible IRA contributions to a Roth. When calculating the amount of tax payable when you convert, you must consider the total of all your IRA accounts. Frequently Asked Questions (FAQs) What is the tax rate on a Roth IRA conversion When you transfer money from a traditional IRA to a Roth IRA, you'll have to pay tax on the percentage of your contributions that you previously deducted. This portion of your income will be taxed at your ordinary income tax rate at the time of conversion. When must a Roth IRA conversion be taxed When you file your taxes for the year in which you made the Roth conversion, you'll have to pay taxes on it. If you convert to a Roth in 2021, you'll have to pay taxes on it when you file your 2021 tax return.