The following is adapted from The Entrepreneur’s Guide to Financial Well-Being.
The biggest difference you’ll find between a traditional IRA and a Roth IRA has to do with taxes. With a traditional IRA, your taxes are deferred until you take a distribution. The opposite is true for a Roth IRA: you pay taxes up front—before you contribute; then your contributions grow tax-free, and when you make a withdrawal, it’s also tax-free.
A traditional IRA might be a smart choice for you if you expect your tax bracket to be lower in retirement. If you think it might be higher, a Roth might be the way to go. A third option could be to hedge your bets and do both. Much depends upon your situation.
A backdoor Roth contribution comes into play when a person with a traditional IRA makes too much money to be able to reap the benefits of a tax-deductible contribution. Here’s an example to show how this works: Edie and Frank are married, filing jointly.
To make a tax-deductible contribution to her IRA, their modified adjusted gross income, or MAGI, would need to be $101,000 or less (assuming Frank is not working) for Edie and Frank to get the full deduction. But they can tap into the benefits of a Roth IRA by contributing to it indirectly (i.e. through the back door). Here’s how it works:
- Frank makes a nondeductible contribution to his traditional IRA.
- He next converts the balance in the traditional IRA to a Roth IRA.
Edie and Frank need to report the original contribution and the conversion on IRS Form 8606. This is important because they need to record their “basis” (the amount of Frank’s IRA contribution for which Edie and Frank have already paid taxes).
Further, Edie and Frank will have to pay taxes on any amount they convert from a pretax account to a Roth, and they may owe taxes on their back-door conversion if Frank still has money left in any other pretax IRA accounts.
Clear as mud? Here’s something else to think about: if Frank’s traditional IRA holds both pre- and after-tax funds, any conversion to a Roth subjects them to the IRS’s pro-rata rule, which some people refer to as the “cream in the coffee” rule.
If you add cream to your coffee, they become mixed and there’s no way to separate the two. It’s the same principle when after-tax dollars go into a traditional IRA, because they’re mingled with pretax dollars, and any distribution involves a mix of both.
In Edie and Frank’s case, if Frank’s traditional IRA held a balance of $200,000, including $20,000 in after-tax contributions, 10% of the balance would be after-tax. Any distribution, then, would include 90% pretax and 10% after-tax dollars. If Frank decides to withdraw $20,000 to help Edie start a new venture, the breakdown follows the same proportions—$18,000 pretax and $2,000 after-tax. The IRA account then has a new balance of $180,000, with $18,000 still considered after-tax dollars.
If Frank tries to do a Roth conversion using this account, he triggers the pro-rata rule. If he moves $20,000 to a Roth, the same formula is in effect, and the $18,000 then appears on the couple’s tax return as taxable.
A number of other rules and exceptions apply, but you get the idea.
A forward-looking adviser will identify these cream-in-the-coffee issues, propose beneficial alternatives, and create a twenty- to forty-year cash flow tax plan to help you stay on top of the tax implications for your retirement savings for the long term.