Every client I’ve introduced to the backdoor Roth regrets not knowing about it sooner. It’s something every high-earner needs to know about, but it isn't for everyone.
This post explains who should use a backdoor Roth, how to do it, the rules you CAN’T overlook, and how to re-open the backdoor if it’s been shut.
Let's see if this tax-free retirement strategy is right for you.
What's the Benefit of a Backdoor Roth IRA?
Investments grow tax-free inside a Roth IRA. Future withdrawals are also tax-free, assuming you meet a few requirements.
However, if your income is too high, you may not be able to contribute directly to a Roth IRA. That's where the backdoor comes in.
The backdoor Roth allows you to add money to your tax-free investments without triggering additional tax in the year you contribute, even if you’re above the income limits.
In addition, you don’t need to consider whether Roth or Traditional (tIRA) contributions are more tax-advantaged because your income is also too high to make a deductible Traditional IRA (tIRA) contribution.
Who Should Use a Backdoor Roth?
If your household’s Modified Adjusted Gross Income (MAGI) is above the limit for the situation that applies to you (see below), you can’t contribute directly to a Roth IRA or make a deductible tIRA contribution.
However, if you have earned income, you can make a nondeductible tIRA contribution, capped at the lesser of your earned income or the annual contribution limit.
If you’re in the position to make nondeductible tIRA contributions, you’re a candidate for the backdoor Roth. So, how do we execute it?
How Does the Backdoor Roth Work?
In a perfect world, the backdoor Roth is as simple as this.
In some situations, it might be this easy. For others, you might need to put in a little extra work.
In either case, you need to know these rules to properly execute it and avoid an unpleasant surprise at tax time.
Making a Nondeductible IRA Contribution
When you make a nondeductible tIRA contribution, it establishes basis in the tIRA. It’s up to you to keep track of the basis on Form 8606 EVERY YEAR when you file taxes.
Tracking the cumulative nondeductible contributions to your IRAs ensures you’ll only be taxed on the pre-tax IRA money when you make withdrawals in the future.
Many people end up with a combination of pre- and after-tax money when they make nondeductible contributions to the same tIRA that they previously:
Made deductible contributions to
Rolled over a pre-tax 401(k) to
If you have a combination of pre- and after-tax money in a tIRA, all distributions are made pro-rata, which brings us to the very important Pro-Rata Rule.
Navigating the Pro-Rata Rule
What does it mean and how does it affect the backdoor Roth? Let’s use an example.
Five years ago you rolled over an old 401(k) to a tIRA and started making deductible IRA contributions. Your tIRA balance is now $100,000 of all pre-tax money. Since then, you got a big promotion and you’re no longer eligible for direct Roth or deductible tIRA contributions, so you decide to start using the backdoor Roth.
You make a $7,000 nondeductible tIRA contribution, and plan to convert it to your Roth IRA. Unfortunately, you can’t choose to only convert the after-tax portion.
Your balance is 93.46% pre-tax ($100k/$107k) and 6.54% after-tax. So, if you converted $7,000, only about $458 would be basis and the remaining $6,542 would be taxed as ordinary income in the year of conversion.
After the conversion, your tIRA balance is back to $100k, your pre-tax balance is $93,458 ($100k - $6,542) and your basis is $6,542 ($7,000 - $458).
You’re probably thinking, “No problem, I’ll just open a separate IRA to make the nondeductible contribution.” Unfortunately, that’s where the second rule comes into play…
The IRA Aggregation Rule
Remember the IRS Form 8606? Well, it’s not just used to track your IRA basis. It’s used to calculate the taxable and non-taxable portion of an IRA distribution, like we did in the example above.
The calculation includes the balances of ALL the traditional IRAs, traditional SEP IRAs, and traditional SIMPLE IRAs in your name.
It’s worth noting that your and your spouse’s IRAs are treated separately.
Also, while it doesn’t help you with the aggregation rule, it may be beneficial to separate previous employer plan rollovers in a Rollover tIRA and direct any contributions to a separate Contributory tIRA.
Let’s build off the above example and say you also have $40,000 in an old SEP IRA you funded while you were doing consulting. You open a new IRA and make the $7,000 nondeductible tIRA contribution, then convert it to a Roth IRA.
After aggregating your IRAs, the combined balance is 95.24% ($140k/$147k) pre-tax and 4.76% ($7k/$147k) after-tax. When you make the $7,000 conversion, about $6,667 would be taxed as ordinary income and only $333 would be tax-free.
If that doesn’t sound very appealing, it’s because it isn’t. However, if you made it here, you get the reward of learning the potential workaround for these rules.
Avoiding the Pro-Rata and IRA Aggregation Rules
401(k)s and other employer plans aren’t included in the aggregation rule.
So, you may be able to roll over pre-tax IRA money to your employer's 401(k), 403(b), etc. and re-open the backdoor.
Most plans allow incoming rollovers of pre-tax balances from IRAs and previous employer plans. However, every plan has specific rules, so you’ll need to read the plan documents or ask your plan administrator to confirm.
In addition, some plans have limited investment options and/or investment options with high expense ratios. You’ll need to evaluate fees, investment selection, and other factors before making a rollover decision.
Conclusion
If you’re a high-earner whose been searching for a way to accumulate more tax-free money without paying extra taxes, you now have the blueprint for executing the backdoor Roth.
Overlooking this strategy can cost you thousands in lost growth and unnecessary taxes, so take advantage if you can!
Looking for a way to move even more money into Roth accounts? Read my post, Build Tax-Free Wealth With The Mega Backdoor Roth.
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