We’ve spent time in previous blog posts discussing the basics of Roth IRAs and the differences between them and Traditional IRAs. A Roth IRA can be an effective tool to save for retirement through tax-free growth of dividends, interest, and capital gains. There’s also potential for tax-free withdrawals from the account during retirement.
The catch is that not everyone is able to save in a Roth IRA: single taxpayers with over $140,000 of annual income and married couples over $208,000 cannot directly make contributions to Roth IRAs. That’s not the end of the story, however. There is a strategy – a “Backdoor” Roth IRA – which allows taxpayers over the income limits to eventually put money in a Roth IRA through a complex series of steps. Through this post, we will cover the basics and help you determine whether a Backdoor Roth IRA is a viable strategy for you.
First, let’s clarify: a Backdoor Roth IRA is not an actual type of account. You cannot go to a bank or online brokerage and open a “Backdoor” Roth IRA. The term “Backdoor” is simply a nickname for the account funding process.
How to do a Backdoor Roth IRA
Step One: Open the account(s).
The first time you do a Backdoor Roth you will need to open two accounts: a Traditional IRA and a Roth IRA. Note, if you already have a Roth IRA, you do not need to open a new one; you can simply use your existing account.
However, if you already have a Traditional IRA (or a SEP or SIMPLE IRA), the Backdoor Roth strategy might not work for you. (Skip ahead to the “When is a Backdoor Roth IRA Strategy Ineffective?” section.)
Step Two: Make a contribution to your Traditional IRA.
The second step is to make a contribution to your Traditional IRA. In 2021, the maximum IRA contribution allowed is $6,000 (or $7,000 for those over 50). Anyone with earned income can make a Traditional IRA contribution; there is no income limit. There is, however, an income cap on who can take a tax deduction for contributions to a Traditional IRA, but, generally speaking, those who are over the Roth IRA income limit will also be over this limit. In other words, that means in this step your Traditional IRA contribution is non-deductible, or is being made with after-tax dollars. As you’ll soon see, this is a crucial part of the Backdoor Roth strategy.
Step Three: Convert it to Roth.
The final step is to convert the $6,000 (or $7,000) Traditional IRA contribution to your Roth IRA. In general this takes place a few weeks or months after your first deposit the funds in your Traditional IRA, although there is no standardized waiting period. Typically you will need to contact your financial institution to facilitate the conversion.
NOTE – a conversion is not the same as a contribution. With a contribution you take a fresh pot of money that has never been inside an IRA and deposit into either a Traditional IRA or a Roth IRA, up to the annual contribution limit of $6,000 (or $7,000 for those over 50). With a conversion, on the other hand, you take funds already inside a Traditional IRA and transfer them to a Roth IRA, which irrevocably re-categorizes its tax status. Contributions can be to a Traditional or to a Roth IRA, but with a conversion you are re-categorizing or reclassifying assets from Traditional to Roth (i.e. from pre-tax to after-tax, and potentially tax-free).
Every year going forward, after the inaugural Backdoor Roth contribution, you can simply follow the second and third steps. Generally, you have until April 15 to make prior-year IRA contributions.
Generally speaking, when you convert Traditional IRA assets to Roth IRA assets you pay tax on any pre-tax dollars being converted, plus tax on any earnings and growth.
With a Backdoor Roth, however, recall that your Traditional IRA contribution in Step 2 was made with after-tax dollars (i.e. you did not get a tax deduction for the contribution). When you later convert the contribution to a Roth IRA you will not pay tax again on the original contribution amount ($6,000 or $7,000), but you will, however, pay tax on any income/gains earned while those funds were inside the Traditional IRA waiting to be converted. How much income or gains you realize will depend on your investment strategy and the length of time the funds sat inside the Traditional IRA. If minimizing upfront taxes is a concern, then ideally you would invest in something very conservative (or not invest the contribution at all), so there would be minimal (or no) income or gains earned in the first place. Thus, if executed correctly, a Backdoor Roth IRA strategy should incur minimal taxes upfront.
Tax Forms / Reporting
If you implement a Backdoor Roth IRA strategy, the tax forms you should be aware of include:
- Form 8606: used to keep track of non-deductible Traditional IRA contributions and Roth conversions
- Form 1099-R: provided by your financial institution to report IRA distributions, and, in this case, conversions
- Form 5498: an informational form which summarizes IRA contributions and converted funds (this form typically arrives in May and thus does not need to be filed with your tax return)
When is a Backdoor Roth IRA Strategy Ineffective?
If you are single and your annual income is less than $140,000 or if you are married with less than $208,000 of annual income, there is no need to implement a Backdoor Roth IRA strategy. You can make normal contributions to a Roth IRA since your income is less than the cut-off limit.
A less obvious instance where a Backdoor Roth IRA strategy might not be effective is if you already have a Traditional IRA, SEP IRA, or SIMPLE IRA filled with pre-tax (i.e., tax deductible) dollars, or if you have a Traditional IRA that was funded via a 401(k) rollover. The reason why is due to an IRS rule – the “Pro-Rata” rule – which requires you to aggregate all non-Roth, non-Inherited IRA assets to determine the tax consequences of a conversion (yours only – you do not need to include a spouse’s IRA assets!). The Pro-Rata rule determines how much of a conversion is taxable versus tax-free. In other words, the Pro-Rata rule prevents you from picking and choosing which IRA assets are being converted during a Backdoor Roth conversion, even if the after-tax Traditional IRA contribution (Step 2) is placed in a completely separate or brand new account!
Pro-Rata Rule Example
John makes $300,000 per year. He is well over the income limit so he cannot make a regular contribution to a Roth IRA; however, he has recently learned about Backdoor Roth IRAs and wants to implement this strategy. In terms of current retirement assets, John has $75,000 in a Traditional IRA that was funded a few years ago from an old employer 401(k) plan, plus $20,000 in a SEP IRA, and $5,000 in a SIMPLE IRA.
John contributes $6,000 to his Traditional IRA, with the intention of later transferring it to a Roth IRA as a Backdoor strategy. Even though it is a non-deductible contribution (i.e. after-tax), the Pro-Rata rule and specifically the existence of his Traditional IRA, SEP, and SIMPLE IRA block him from siphoning-off only the $6,000 of after-tax money during Step Three of the Backdoor Roth strategy.
This has the effect of making a portion of his $6,000 Backdoor Roth conversion partly taxable and partly non-taxable. To calculate that ratio, first add up the value of all IRA assets – Traditional, SEP, and SIMPLE – which for John equals $106,000 ($75,000 Traditional + $20,000 SEP + $5,000 SIMPLE + the $6,000 after-tax contribution). Then divide the after-tax contribution ($6,000) by the total value of IRA assets ($106,000). The resulting percentage of 5.66% means only 5.66% of his conversion is tax-free. In other words, when John converts $6,000 to his Roth IRA, only $340 will be considered tax-free and he will pay income tax on the other $5,660. By contrast, consider that if John had no Traditional, SEP, or SIMPLE IRA assets then the entire $6,000 conversion would be tax-free.
Simply put, the Pro-Rata rule can create a sizeable upfront tax burden that can possibly negate any long-term benefits of having that money in a Roth account.
One potential way to work around the Pro-Rata rule is to transfer Traditional IRA, SEP IRA, or SIMPLE IRA assets into your workplace retirement plan. The Pro-Rata rule does not factor-in assets inside employer plans such as 401(k)s, 403(b)s, TSPs, or profit-sharing plans, for example. However, you will first need to confirm whether your company plan accepts outside transfers.
If this is not available, then one other solution would be to convert the entire pre-tax Traditional IRA (or SEP IRA/SIMPLE IRA) into a Roth IRA either in one fell-swoop or in annual chunks. Then, after all pre-tax IRA dollars are depleted, you can start doing Backdoor Roth conversions going forward. It is imperative to carefully weigh the pros and cons of this alternative beforehand, however, because converting an entire pre-tax IRA in could create a large tax bill, which, again, may negate any benefits of having that money in a Roth account.
The Bottom Line
The Backdoor Roth IRA strategy is not a viable option for all investors. It’s important to speak with your financial advisor and tax preparer to understand the steps involved and the potential tax implications.
If you have any questions, please reach out to our team here at Taylor Hoffman!
Taylor Hoffman is an SEC registered investment adviser with its principal place of business in the State of Virginia. Any references to the terms “registered investment adviser” or “registered,” do not imply that Taylor Hoffman or any person associated with Taylor Hoffman have achieved a certain level of skill or training. Taylor Hoffman may only transact business in those states in which it is registered /notice filed, or qualifies for an exemption or exclusion from registration /notice filing requirements. For information pertaining to the registration status of Taylor Hoffman or for additional information about Taylor Hoffman, including fees and services, please visit www.adviserinfo.sec.gov.
The information contained herein is provided for informational purposes, represents only a summary of the topics discussed, and should not be construed as the provision of personalized investment advice or an offer to sell or the solicitation of any offer to buy any securities. The contents should also not be construed as tax or legal advice. Rather, the contents including, without limitation, any forecasts and projections, simply reflect the opinions and views of the author. All expressions of opinion reflect the judgment of the author as of the date of publication and are subject to change without notice. There is no guarantee that the views and opinions expressed herein will come to pass.
This document contains information derived from third party sources. Although we believe these third party sources to be reliable, Taylor Hoffman makes no representations as to the accuracy or completeness of any information derived from such third-party sources and takes no responsibility therefore.
Taylor Hoffman is not a Public Accounting firm, and the information contained herein should not be construed as tax advice. Rather the contents included are a reflection of the view and opinions of the author. There is no guarantee that the information provided fits every situation, and individuals should consult their tax advisor for more specifics.
Taylor Hoffman is not a law firm, and the information contained herein should not be construed as legal advice. Rather the contents included are a reflection of the view and opinions of the author. There is no guarantee that the information provided fits every situation, and individuals should consult their attorney for more specifics.