Updated: April 2021
Why Is This a Topic of Interest?
Investors and advisors constantly seek tax-free, not just tax-deferred, income. This planning tool provides that possibility. However, “there is no such thing as a free lunch”, so let’s look at the complexity of pursuing this strategy with the intention of getting tax-free income.
What is a Backdoor Roth IRA Conversion?
A backdoor Roth IRA conversion (sometimes called a backdoor Roth IRA, despite it not being an account) is a two-step process allowing individuals with Modified Adjusted Gross Income (MAGI) above certain thresholds to contribute to a Roth IRA by:
Making a Traditional (usually non-deductible) IRA contribution
Moving that contribution to a Roth IRA
A Backdoor Roth IRA Conversion is not
It’s easy to get lost in tax terms, Traditional vs Roth, IRAs vs 401(k)s, SEP vs SIMPLE IRAs, so let’s review a few things that a backdoor Roth conversion is:
Not An Account
A backdoor Roth IRA conversion is a process involving two accounts - a Traditional IRA and a Roth
IRA; it is not itself an account.
Not An Actual Conversion
Furthermore, the Traditional IRA is not “converted” literally to a Roth IRA; money is moved from the Traditional IRA account to the Roth IRA account. Yet we will continue to use the term “conversion” since it is so widely used.
Not A Mega Backdoor Roth IRA Conversion
The goal of a “mega” is the same as a backdoor Roth IRA conversion, namely get money into a Roth IRA account for eventual tax-free withdrawals. However, the “mega” variant requires the use of a 401(k) plan with specific characteristics such as higher contribution limits than a “non-mega” backdoor Roth IRA conversion. The rules and mechanisms are different enough that this process deserves a separate post.
Not A Method to Avoid Paying Taxes Immediately
If you meet the eligibility requirements, money in a Roth IRA can be withdrawn tax free, but tax must be paid before making contributions to a Roth IRA. A backdoor Roth IRA conversion is a retirement planning tool that may reduce your tax burden on withdrawals in the future but should have no impact on your income taxes owed on earnings in the current year.
Why Fund a Roth IRA?
Each year the IRS provides a table and instructions, based on MAGI, to let tax filers know how much, if anything, can be contributed to their Roth IRA.
Source: IRS.gov - Amount of Roth IRA Contributions That You Can Make for 2020 A backdoor Roth conversion allows tax filers above the various income thresholds to contribute to a Roth IRA. In most cases, people utilizing a backdoor Roth conversion have already exhausted contributions to other tax-advantaged accounts such as:
Colleges Savings Plans
If you haven’t investigated these options, they may be more suited to your needs.
What about Traditional IRA MAGI Limits?
Unlike Roth IRA’s, MAGI is not a disqualifier from contributing to a traditional IRA, but the individual may not qualify for a tax deduction as influenced by 3 factors:
Are you or your spouse covered by a retirement plan at work?
What is your MAGI?
What is your tax filing status?
The IRS provides two different tables to cover these factors. This first table is used if YOU ARE covered by a retirement plan at work:
If YOU ARE NOT covered by a retirement plan at work, the IRS provides this table:
As you can see, from the tables, MAGI only affects whether you can take a deduction for contributing to a Traditional IRA, not whether you can contribute. Lastly, if you’re unsure whether you’re covered by an employer’s retirement plan, the IRS issues guidance on that too. The easiest way to confirm that you were covered is to check your Form W-2, Box 13, for a check mark on “Retirement plan”.
Non-deductible Traditional IRA Contributions vs Roth IRA Conversion
For those who have exhausted other tax-advantaged account contribution options, a non-deductible Traditional IRA contribution might be better than nothing. If you have income that you have already paid tax on, putting that money into a Traditional IRA will allow it to grow tax deferred while still allowing you to rebalance or trade in your portfolio without an immediate tax impact. The downside is that you are subject to all the Traditional IRA eligibility requirements, i.e. age, before the money can be withdrawn, and you are subject to Required Minimum Distributions (RMDs) at a certain point.
The Roth IRA conversion takes a non-deductible Traditional IRA contribution a step further by subsequently moving that money into a Roth IRA. Now investment gains on that money will be tax-free upon withdrawal rather than just tax-deferred. Roth IRAs are not subject to RMDs and follow different withdrawal rules. A Roth IRA conversion generally provides a greater tax advantage than stopping after a non-deductible Traditional IRA contribution, but given the added complexity, you should seek guidance from a qualified accountant or tax preparer if the process is unclear to you.
Common Errors with Roth IRA Conversions
This isn’t a complete list, but there are some common mistakes DIYers (and some pros) make:
There isn’t a limit to the number of Traditional IRA accounts you can open, but the federal government views multiple Traditional IRA accounts under one name as just one savings vehicle for that person, with some money from deductible contributions, and other money from nondeductible contributions. Let’s break down why that matters upon conversion to a Roth IRA.
When money from 100% deductible contributions is moved from a traditional IRA to a Roth IRA by an individual, tax is owed in the tax year of the contribution, depending on your filing status and MAGI, on 100% of that money because no tax was ever paid on that income. An individual that can contribute to a Traditional IRA and claim a full deduction would likely be able to contribute to a Roth IRA directly and would have no need to employ a backdoor Roth conversion.
In contrast, money from 100% non-deductible contributions is not taxed when moved from a traditional to a Roth IRA because tax was already paid on that income. Double emphasis on the word “contributions” as “earnings” would be treated as taxable in the tax year of the contribution since tax has never been paid on them (see common errors below). Note that it is irrelevant whether your spouse has deductible contributions, as the federal government recognizes the “I” in IRA being for individual, and the money is not considered to be intermingled by spouses.
The situation gets complicated when an individual has Traditional IRA money from deductible (pre-tax) and non-deductible (post-tax) balances, whether they are in separate accounts or not. When a Roth IRA conversion occurs, the conversion must occur on a pro-rata (proportional) basis between deductible and non-deductible balances. As an example, let’s say Elizabeth makes a non-deductible contribution to a new Traditional IRA of $5,000 in the current tax year with the intent to move (convert) that $5,000 to a Roth IRA. She also happens to have a Traditional IRA with $45,000 of pre-tax contributions and earnings as the result of a Traditional 401(k) to Traditional IRA rollover from her previous employer. If Elizabeth goes to move $5,000 to her Roth IRA, she will be forced to move 10%, $500, of the post-tax balance, which will not be taxed, and 90%, $4,500 of the pre-tax balance, which will be taxed. This is unlikely the desired goal of a backdoor Roth IRA conversion. Unfortunately, this rule applies to SEP and SIMPLE IRAs as well, but it does apply to 401(k)s. In fact, if Elizabeth had ignored the many articles and people espousing the benefits of rolling over an old 401(k) into a Traditional IRA, she would have been in a much simpler situation and not had to pursue a more complicated workaround discussed later.
Ineligibility for Traditional IRA Contributions
Just because MAGI doesn’t preclude individuals from making Traditional IRA contributions, that does not mean that everyone is eligible. The 70 ½ age requirement is gone as of Jan 1, 2020, but individuals still must have qualifying income to contribute. For example, if all your income came from investments or rental properties, you may be ineligible. However, if your spouse has enough qualifying income to cover both of you, then you can both contribute to your respective Traditional IRAs provided you also file jointly. Additional details in the IRS publication section “Kay Bailey Hutchison Spousal IRA Limit”.
Five Year Conversion Rule:
There are actually 3 different five-year conversion rules regarding Roth IRAs:
Withdrawing earnings from a Roth IRA
Inheriting a Roth IRA
Withdrawing Traditional-to-Roth-converted dollars from a Roth IRA
This post is concerned with the last bullet, and it causes confusion because one of the benefits of a Roth IRA is that contributions are generally not subject to any timeframe for withdrawal. However, we must be careful distinguishing between contributions and conversions. The complexity is compounded by the Roth IRA ordering rules governing withdrawals in which contributions must be withdrawn first, followed by conversions, then earnings. Each conversion is subject to its own five-year waiting period, so if you suspect or are unsure if five years have passed, it is likely time to seek professional help. Keeping good records of contributions is very helpful also.
Step Doctrine + Investing + Pro Rata Rule
Two types of fear, fear of missing out (FOMO) and fear of the step doctrine (FOTSD?), are the combined sources of another common error, or at least complication. Prior to the Tax Cuts and Jobs Act (TCJA), the Roth IRA conversion had questionable legality. Making a non-deductible contribution to a Traditional IRA and performing a Roth IRA conversion were legal but contributing directly to a Roth IRA above certain MAGI thresholds was illegal. In a nutshell, the step doctrine is a catch-all that prevents individuals from taking a series of legal steps that reproduce an illegal action. It is easy to see how this could apply to backdoor Roth IRA conversions, and despite wide-spread popularity and use, the legality of backdoor Roth IRA conversions wasn’t clarified until recently. This unknown often led individuals to make non-deductible contributions, wait an unspecified amount of time, then perform the conversion to create some doubt that this combination of steps was one act. If the money sat uninvested in the Traditional IRA, there were no complications, but if the money was invested and grew, now the conversion was subject to the Pro Rata Rule because both tax-deferred and post-tax dollars exist. It’s not the worst problem to have made money from an investment and pay taxes on those earnings, but the goal of the conversion was to accumulate tax-free growth, and an individual wouldn’t have been able to take a taxable loss if the investment went down. Fortunately, the TCJA, specifically page 289, footnote 268 (and a few others), states “Although an individual with AGI exceeding certain limits is not permitted to make a contribution directly to a Roth IRA, the individual can make a contribution to a traditional IRA and convert the traditional IRA to a Roth IRA”.
Navigating the Pro-Rata Rule
As discussed in an earlier example, it is a bit silly that Elizabeth was subject to the pro-rata rule because she converted her previous employer’s 401(k) to a Traditional IRA but would have been fine if she left the 401(k) alone. It’s a common occurrence, but individuals that have performed a 401(k) to Traditional IRA rollover may still have options. If you are currently covered by an employer’s 401(k), you may be able to perform a direct rollover from your Traditional IRA into your 401(k) in order to consolidate tax-deferred accounts. Not all plans allow this, and it will likely require working with your human resources department. If you’re self-employed, or can become self-employed, you may consider a solo 401(k) to accomplish the same goal, but you may need some professional assistance.
As you might expect, utilizing a tax strategy will require you to file an additional tax form, in this case, Form 8606. Part I covers non-deductible contributions to Traditional IRAs and Part II covers conversions from Traditional to Roth IRAs. Investigate the form and please do not attempt a backdoor Roth IRA conversion if you don’t understand how to fill out and file form 8606. Even if you hire a professional, it is best practice to review their work and ensure the form is filled out correctly.
When done correctly, a backdoor Roth IRA conversion can offer tax advantages that enhance an overall retirement plan regardless of what retirement looks like to you. There are many complicating factors, including specific situations and details not covered in this post. The backdoor Roth IRA conversion is only one of many strategies available to help fund a successful retirement, so it is important to consider all your options to make the best choice for you.
Author: Andrew Dudar is a registered investment adviser representative at JRW Advisory Services, serving clients in Colorado and across the United States where exclusions apply.
Disclaimer: The article is written for the purpose of general education and information and should not be taken as tax advice. Please consult with a qualified accountant or tax professional before acting on or making decisions about your unique tax situation.