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Money School: Backdoor Roth Contributions


Last time, I wrote about how to decide whether to make your traditional pre-tax retirement contributions, after-tax Roth contributions, or a combination, as well as how to prioritize saving inside your employer plan, or outside in an IRA. I mentioned that even though Roth IRA contributions are subject to income limits, there is a way for even high earners to get some money in that bucket every year, commonly referred to as making backdoor Roth contributions. It's an important planning technique because Roth IRA savings are so powerful - the tax-free growth AND tax-free distributions AND lenient rules around withdrawals mean everyone should really consider them, regardless of income level. 

How it works:

  • Ensure no pre-tax IRA balances exist. This includes, Traditional, Rollover, SEP and SIMPLE IRAs (but not beneficiary or inherited IRAs) If there are, roll those funds into a qualified plan such as a 401k or 403b. If this isn’t possible, hold off on executing the strategy since it will negate the tax benefits you are trying to capture.

  • Establish, and make a contribution to a Traditional IRA. This contribution will not be deducted on your taxes. You can leave the contribution in cash for now. 

  • The next month, convert the balance in the traditional IRA to a Roth IRA. Invest the funds according to your preferred strategy. 

  • Ensure no small balances remain in the Traditional IRA. If so, request that your custodian convert those as well. 

  • The next year, repeat the process. You will owe taxes on any gain that occurs between the contribution and the conversion dates (but that should be minimal if you left the contribution in cash)

Who should use it:

  • Those who earn too much to make outright Roth contributions. See here for the IRS limits for 2018. If your AGI is below these levels, just contribute directly to the Roth IRA (through the front door) - no need for the extra steps.

  • Have already made their other contributions (maxed out their 401k, for example)

  • Can afford to put more aside without incurring cash flow difficulty

Considerations:

  • It's an IRS gray area - there's always the risk that the loophole will be closed at some point

  • Form 8606 needs to be filed with your taxes

  • To reiterate the above, it's very important to make sure no other IRA assets exist. If there are, you will be subject to the pro-rata rule. Let's say that you had $94,500 in pre-tax IRA balances, and you contribute another $5,500 with the intent to convert those dollars to the Roth IRA. You now have $100,000 in total. Even if that $5,500 is in a new Traditional IRA opened just for this purpose, the IRS will consider that only 5.5% of your conversion amount was actually post-tax and 94.5% were pretax dollars that got converted, and are subject to income tax. So now, you've created a situation where you will owe income tax on $5,197.50 as well as having $302.50 of after-tax dollars remaining in the Traditional IRA that will need to be tracked through the years to avoid paying tax on them AGAIN when you withdraw them in retirement. As you can see, it basically wipes out the benefit of the strategy

  • Spouses make their contributions separately, and their IRAs are not commingled. So if one spouse has a traditional IRA balance with no opportunity to move it to an employer plan for the time being, but the other spouse has a clear path, there's no reason to wait on executing the strategy for spouse 2. 

  • Keep the statement to prove contributions were made correctly

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