You’ve heard about this thing called a ‘backdoor Roth IRA,’ but what is it exactly, who uses it, and when is the right time to consider it?
First, a little preamble. Roth IRAs are a wonderfully tax-advantaged retirement savings account that allow you to save and grow your money tax-free after you pay taxes on your initial contribution. Talk about giving people an incentive to save! But, as people quickly realize, there are contribution and income limits associated with Roth IRAs.
For 2019, the maximum annual amount you can contribute to a Roth IRA is $6,000. If you are 50 years old or older, you can contribute $7,000. Relative to how much you are saving toward retirement in total, this is likely just a small (but mighty) portion of your retirement portfolio.
If you are like many of my clients, you may be at the point where you make too much money to contribute to your Roth IRA account anymore. In 2019, if you are single, your adjusted gross income has to be less than $137,000 to contribute to a Roth IRA, and if you are married filing jointly, your adjusted gross income can’t be higher than $203,000.
So, if you make too much money can you still contribute to a Roth IRA account? In some cases, yes you can with a little administrative legwork called a backdoor Roth IRA conversion.
What’s the difference between a regular Roth IRA conversion and a backdoor Roth IRA conversion?
In both cases, the destination account is a Roth IRA. The difference between these two types of conversions is the sequence of accounts that come before the Roth.
A regular Roth IRA conversion takes pre-tax IRA contributions that are sitting in a Traditional IRA and converts them to a Roth IRA. Then, you include the amount you convert in your taxable income for the year and pay ordinary income taxes on the converted amount.
A backdoor Roth IRA conversion takes funds from a non-deductible Traditional IRA and converts them to a Roth IRA. And since you’ve already paid taxes on those dollars, you don’t include them in taxable income again.
The Backdoor Roth IRA Conversion
A backdoor Roth IRA conversion allows people with high incomes, especially those who don’t have access to another employer-sponsored retirement account, such as a 401(k), to save tax-advantaged money in a Roth IRA. It’s simple in the sense that if you don’t have another IRA account, you add funds to a Traditional IRA as an after-tax contribution, convert it to a Roth IRA account, and voila.
Well, not exactly “voila.” There are certain tax implications to consider first.
Here is a quick summary of backdoor Roth IRA conversions and what you’ll want to consider carefully before doing one.
A quick summary about Backdoor Roth IRA Conversions:
- You likely wouldn’t consider this if you have other IRA accounts because portions of those accounts now become taxable and it quickly turns into a big bookkeeping problem.
- The converted amount is not subject to the annual contribution limits, but the amount you add to your after-tax traditional (otherwise known as “non-deductible”) IRA is subject to the contribution limits. In 2019, that’s $6,000 max, or $7,000 if you’re age 50 or older. So that becomes the maximum amount of an annual backdoor Roth conversion.
- They are not subject to income limits.
- You need to have earned income in at least the amount of the contribution to contribute to a non-deductible IRA.
- If you’re under 59 and a half, you have to wait five years before you can touch your converted funds penalty free. The earnings are yours to keep from Day 1.
- You may have to pay taxes on the growth of the converted amount if the funds grew between contributing them to the after-tax traditional/non-deductible IRA and converting them to the Roth.
When Does it Make Sense to Do a Regular Roth IRA Conversion?
When it makes sense to do a Regular Roth IRA conversion is personal and is highly dependent on your situation and financial goals. A common reason to consider a Regular Roth IRA conversion is if you can save money in the long-run by paying taxes now versus at the point when you start taking distributions. This would mean that your tax rate in retirement is higher than your current tax rate.
- Usually, when you contribute to a Traditional IRA, you put after-tax money in the account, deduct it on your tax return in the year of the contribution, and pay taxes on your principal contributions and gains when you start taking distributions.
Why Do a Backdoor Roth IRA Conversion?
People do backdoor Roth conversions when they make too much income to contribute to a Roth or pre-tax IRA directly from their earned income. It is a way for wealthy people to continue utilizing this retirement savings tool.
- When you contribute to your Traditional IRA, you also have the option NOT to deduct the IRA contribution from your taxes, thus making an after-tax contribution. In doing this, it likely makes the most sense to go ahead and convert the dollars straight to the Roth (thus resulting in the backdoor Roth Conversion).
What Are the Common Mistakes People Make When Doing a Backdoor Roth IRA Conversion?
Making any big financial decision without fully understanding how it will impact your overall financial situation is one of the biggest mistakes people make when it comes to backdoor Roth IRA conversions.
The biggest mistake people make when attempting a backdoor Roth conversion is co-mingling pre-tax and after-tax dollars in the IRA. As mentioned before, the IRS considers all IRA dollars to have the same taxable character, via the pro rata rule. For this reason, the best candidates for a backdoor Roth conversion are people who have zero dollars in Traditional IRAs, SEPs, SIMPLEs, and the like.
Here’s how a backdoor Roth IRA conversion would work under the pro rata rule:
Let’s say you have $54,000 in your Traditional IRA. Then, you contribute $6,000 to a non-deductible IRA and convert that to a Roth. Now the pro rata rule applies.
On December 31st of that year, the IRS will sum the balances of all of your IRAs (but not your Roth IRA). In this case, $54,000 plus the $6,000 non-deductible contribution is $60,000. Now divide the amount of the conversion ($6,000) by the total IRA balance ($60,000) and you get 10%. The IRS considers 10% of your Roth conversion to be free from tax, but the remaining 90% of $6,000 ($5,400) is considered Ordinary Income and is fully taxable at your current tax rate. Obviously, this isn’t ideal if you were expecting a non-taxable transaction!
Some advisors recommend rolling IRAs into your employer-sponsored plan (401(k) balances wouldn’t be considered in the calculation of your IRA balances), but this is usually a costly tactic. 401(k) plans are notorious for having limited and expensive investment options, which would lower your returns in future years, and subsequently your net worth. Not only that, but you lose control of your hard-earned IRA dollars, because depending on your plan features, you may not be able to roll them out of the employer plan until you no longer work for that employer!
This is why ideal conditions for a backdoor Roth conversion are so rare.
How to Approach a Backdoor Roth Conversion
A backdoor Roth IRA conversion is not something I recommend you do yourself. The more money you have and the closer you are to retirement, the greater the consequences if you get this wrong. Instead, work with your financial advisor or contact me to review your overall financial situation and assess whether or not a backdoor Roth IRA conversion makes sense. If it does, then your financial advisor can create a strategy for how to do it so that you don’t inadvertently harm your financial trajectory.