In my previous Roth IRA basics post, I received the following question from a reader, Julia:
“Great summary, but I think it’d be interesting to hear about the Backdoor Roth IRA option. Doesn’t the Back Door Roth essentially eliminate all income restrictions on Roths?”
It’s a great question. I’ve been neglecting the Backdoor Roth IRA topic entirely for reasons I’ll discuss towards the end of this post.
But before we get that far, let’s first cover what a Backdoor Roth IRA is and how it works.
What is a Backdoor Roth IRA?
A Backdoor Roth IRA is a way for high income earners to make Roth IRA contributions through the ‘back door’ by first making non-deductible contributions to a Traditional IRA, and then converting those contributions to a Roth IRA. Doing so allows for incremental positive long-term tax-advantaged retirement savings.
High income earners, specifically those who are above the Roth IRA income limits, cannot contribute directly to a Roth IRA. In order to reap the benefits of a Roth IRA, they must take advantage of an IRS loophole and contribute through the non-deductible Traditional-to-Roth conversion instead. There is no income limit on making a non-deductible contribution to a Traditional IRA.
You heard “non-deductible contributions” right. Traditional IRA contributions are typically deductible, whereas Roth IRA contributions are not (with Roths, you pay tax now, but future earnings and withdrawals are tax free at retirement). This is the key component that makes the Backdoor Roth conversion possible.
Note: if you are below the Roth IRA income limits, then you can contribute directly to a Roth IRA (or even better, in my opinion, make a deductible contribution to a Traditional IRA) and conveniently forget all about the Backdoor Roth.
Backdoor Roth IRA Steps: How Does a Backdoor Roth IRA Conversion Work?
At its simplest level, here are the Backdoor Roth IRA conversion steps:
Step 1: Taxpayer has both a Traditional IRA and Roth IRA with the same broker (if not, they can open them with an online discount broker).
Step 2: Taxpayer reaches an income level that is over the Roth IRA contribution income limit in a given year.
Step 3: Taxpayer makes a non-deductible contribution to a Traditional IRA for that tax year (up to the maximum IRA contribution).
Step 4: After the contribution posts to the account (typically as soon as next day or after), taxpayer then converts 100% of the funds from the Traditional IRA to a Roth IRA.
Step 5: Taxpayer does not claim a deduction for the IRA contribution and fills out IRS Form 8606 when completing their taxes.
Backdoor Roth IRA Dangers (i.e. the Pro-Rata Rule & Step Transaction Doctrine)
Backdoor Roth IRA’s are not foolproof. If you do them incorrectly, they can result in over-taxation or worse.
If you have any pre-existing deductible funds in any Traditional IRA, SEP IRA, or SIMPLE IRA, these types of accounts are all lumped together for the conversion and you cannot convert just the non-deductible amount. This is called the pro-rata rule. It’s best illustrated with an example.
- You have $50,000 in total IRA assets.
- $10,000 of those assets are non-deductible contributions.
- 20% ($10,000/$50,000) of your assets are non-deductible.
Due to the pro-rata rule, in this example, any partial conversion is considered 80% taxable and only 20% non-taxable, which would wipe out much of the benefit of making the conversion because those who need to do the Backdoor conversion in the first place are in high tax brackets and would be paying high taxes on the deductible portion.
Therefore, it makes sense to roll-over any deductible SEP-IRA, SIMPLE IRA, Traditional IRA funds into an employer-sponsored 401K (which are considered separate funds and don’t count towards the pro-rata rule) first before executing a Backdoor Roth IRA conversion, or else you could be stuck with a significant tax bill for the previously deducted portion of the conversion. Not every 401K allows this type of conversion, however.
Sound complicated? It is.
There is also the matter whether Backdoor Roth IRA’s are technically legal. There is no mention of the Backdoor Roth IRA on the IRS website because the IRS does not acknowledge their own loopholes.
The Step Transaction Doctrine essentially states that if an individual act is not permitted, then it is also not permitted through a series of legal steps. Backdoor Roth IRA Conversions are common and the IRS coming after people is unlikely, yet just the threat may be reason enough to stay away.
This post is not an endorsement or advice to use the Backdoor Roth IRA conversions. Understand the risks and consult with a professional before executing a Backdoor Roth IRA conversion. Most readers here will not earn enough income to need to use the Backdoor Roth (check the limits). And those who do who are aware of the risks should proceed with caution.
What About the Mega Backdoor Roth?
A mega backdoor Roth, is a way for you to make after-tax contributions to a 401K and then convert them to a Roth IRA or Roth 401K. If your employer allows them, and you have the cash for to make it work, they are worth exploring further to give an extra boost to your retirement savings.