The strategy of a backdoor Roth IRA contribution seems to be coming up more and more in conversations in the media. There are a few key things to know about the process, who is eligible, the IRS pro-rata rule, and how the conversation in Washington DC could impact the strategy. First, for the basics of the strategy.
A backdoor Roth IRA is a type of conversion that allows people with high incomes to fund a Roth IRA despite IRS income limits. Roth IRAs are unique in that they allow money to grow tax-free and be withdrawn tax-free (if you follow the Roth IRA distribution rules) when you need the funds down the road. This type of account is an incredibly useful tool for retirement income planning and was designed to help lower- and middle-income families save for retirement by allowing for tax-free growth. For 2022 you are allowed to fully contribute to a Roth IRA if your income is $129,000 or below for single filers, or $204,000 for married individuals. If you have income above those limits the amount you can contribute starts to phase out and is eliminated for single filers at $144,000 and $214,000 for married individuals filing jointly.
To complete the backdoor strategy, you first contribute post-tax money into a nondeductible Traditional IRA, then convert your contributed funds into a Roth IRA. To minimize the chance of having to deal with any taxes, it’s ideal to complete the IRA contribution and subsequent Roth IRA conversation on the same day.
One rule to be aware of when using this strategy is the IRS pro-rata rule which requires IRA rollovers to be done, like the name says, pro-rata or proportionally from a taxable perspective. Keep in mind the IRS will look at all your IRA accounts combined, this includes Simple and SEP as well as Traditional. If you have both nondeductible and deductible IRA funds, each dollar withdrawn, or converted, will contain a percentage of tax-free and taxable funds. Unfortunately, this means you cannot ‘choose’ only the after-tax funds to convert, you need to pro-rate the funds based on taxability. To do this you have to come up with the percentage of your total amount that is made up of taxable dollars (taxable dollars divided by total amount in all IRA’s) and the percentage of your total amount that is non-taxable dollars (nontaxable dollars divided by total amount in all IRA’s). Once you have these percentages you can determine the taxability of any withdrawals taken. Having an open conversation with your tax professional about this strategy is best. If they know, they can advise you as to your eligibility and the advisability of this strategy. In addition, they will help you keep track of the basis and taxability of the transactions.
As you can imagine, over time, this task of keeping track of taxability within each account can be onerous which is why it is smart to consider this before you make decisions with IRAs. One of the lesser-known pitfalls here is the idea of doing a rollover from a 401k to an IRA. It’s common when leaving a job to think about rolling your old 401k over into an IRA, but when you take the money out of a 401k and put it into an IRA, in the IRS’s view you have created a ‘deductible’ IRA. Therefore, if you wanted to engage in a backdoor Roth strategy you would have to prorate your conversion. This may not be a reason not to complete the 401k to IRA rollover, but it is something to consider and talk to your accountant and financial planner about.
In the last half of 2021, there was much conversation in Congress about closing this ‘loophole’, as many see it. As of now, there is nothing that has been passed, but that does not mean that it will not come up again. Many see this strategy as an abuse of this special type of account by the wealthiest Americans, and therefore it’s top of mind. This is certainly something we will be keeping an eye on as new legislation is proposed.
~ Emily Lucero, CFP®