In RCs and I Ain’t Talking Cars, I explained what a Roth conversion is, how to complete the process, and why you may want to consider it. But I didn’t talk about the backdoor Roth. While it’s technically a Roth conversion, the execution is slightly different.
If you’re unfamiliar with the differences between Traditional IRAs and Roth IRAs, read Traditional or Roth IRA – Which Should I Choose? before reading this blog.
The Backdoor Roth is the Trojan Horse of IRAs
The backdoor Roth isn’t an IRA. It’s a process for high-income earners to fund a Roth even when their income levels are above the Roth IRA contribution limits. It may sound a bit dubious, and it was until late 2017. Until December of 2017, backdoor Roth IRAs were a gray area because the tax code didn’t specifically recognize this process. That changed when the IRS finally gave them the stamp of approval. Surprisingly, the IRS didn’t oppose the process, but they weren’t fond of the name.
Who Should Consider a Backdoor Roth?
The backdoor Roth allows you to sidestep the Roth IRA’s income limits. You should consider a backdoor Roth if you’re single, covered by an employer-sponsored plan, and your income exceeds the IRA deduction limits, or if you’re married and, you, your spouse, or you’re both covered by employer-sponsored plans, and your income exceeds the IRA deduction limits. If you don’t fall into these two categories, you don’t need to worry about a backdoor Roth because you can fund a Roth IRA.
How a Backdoor Roth Works
The two most common ways to execute the backdoor Roth are by funding an existing Traditional IRA or opening a new Traditional IRA specifically for this purpose. In either scenario, the investor will contribute as much money as they’d like up to the IRS’s limits.
From there, the investor will immediately convert the recently contributed Traditional IRA dollars into a Roth IRA. Because the investor is not eligible for a tax deduction, there will not be taxes due if done correctly.
Rules to Know When it Comes to the Backdoor Roth
Before deciding to go the backdoor Roth route, you should understand the nuances of the rules. Until the Tax Cuts and Jobs Act (TCJA) of 2017, an investor who completed a conversion could recharacterize the conversion, essentially allowing the money to go back into a Traditional IRA. Recharacterization was almost a get out of jail free card. If you realized you made a mistake or no longer wanted to go through with the transaction, you could reverse it. Due to the TCJA, that option is no longer available. So before completing the conversion, make sure you understand all the rules and regulations.
The Pro-Rata Rule
The pro-rata rule in section 408(d)(2) of the Internal Revenue Code states that all individual retirement plans should be treated as one account. Understanding this rule is crucial if you’re making a non-deductible contribution.
No Existing Tax-Deferred IRAs
If you have no other tax-deferred accounts, e.g., Traditional IRA or SEP IRA, you can make your non-deductible IRA contribution and convert it into a Roth without incurring a tax bill on the conversation, if done correctly.
Backdoor Roth with Existing Tax-Deferred IRAs
You’ve changed jobs, and along the way, you consolidated 401ks from previous jobs into an IRA. That IRA has a current value of $500,000. You aren’t eligible for a Roth IRA and can’t take a tax deduction on a Traditional IRA. So, you decide to make a backdoor Roth contribution. You deposit $6,000 into your IRA.
In an ideal world, you would contribute the $6,000 to the Traditional IRA, and because it’s non-deductible, you’d convert the entire amount into a Roth IRA without any taxes due. However, because this isn’t an ideal world, you need to understand this rule.
If you attempt to convert the new contribution of $6,000, you must factor in the additional $500,000 in the IRA to determine the taxes due on the conversion.
o Calculate the non-taxable portion:
Total after-tax contributions/total non-Roth IRA balance = Non-taxable percentage
$6,000 / $506,000 = 1.18%
o Calculate the non-taxable portion
Non-taxable percentage x amount to convert = non-taxable conversion amount
18% x $6,000 = $70.80
o Calculate the amount added to your taxable income:
Amount to convert – non-taxable conversion amount = amount added to taxable income
$6,000 – $70.80 = $5929.20
Upon completion of the backdoor Roth, only $70.80 of the $6,000 conversion is non-taxable. The conversion will result in a Roth IRA with $6,000, a Traditional IRA with $500,000, and in increased tax bill from the conversion of $5,929.20. Due to the pro-rata rule and the potential for a limited tax benefit, you want to weigh your options before completing this irrevocable transaction.
The Five-Year Rule
After the backdoor Roth transaction is complete, the IRS requires a waiting period of five years before withdrawing the converted balance. Failure to meet the required time will result in the investor incurring a 10 percent penalty on the distribution. Each conversion has its own five-year period.
These are just two of the many tax consequences that an investor should consider before completing the transaction. If an investor doesn’t plan properly or makes the wrong decision, a conversion may increase their taxable income, push them into a higher tax bracket, and create unnecessary and unintended consequences. I would encourage every investor who’s considering a backdoor Roth to retain a tax professional’s services before completing this irrevocable transaction. Under the right circumstances, a backdoor Roth can be a great complement to your current financial plan.