Most terms in the world of personal finance muddy the waters far more than they provide clarification. One of these terms is the Backdoor Roth Conversion which is often confused with the simpler Roth Conversion. Both can be useful strategies depending on your situation, but backdoor Roth conversions are a little bit more complex due to the potential pitfalls involved.
President Biden's tax proposal was potentially going to eliminate this strategy from being legal but it appears now that it will continue to be permitted going forward. Continue to mind the potential upcoming tax changes and discuss them with an advisor before making any changes to your situation.
Is a backdoor Roth conversions appropriate for you? Should you complete a backdoor Roth conversion? What are some common mistakes when completing one? Let's take a deeper look at the details below.
Backdoor Roth Conversion Vs. Roth Conversion
We very frequently see confusion around these two common strategies which is understandable because they are similarly named and involve similar movements. That said, they can apply to vastly different people and situations.
A Roth conversion refers to transferring money from a Traditional IRA to a Roth IRA. The catch with Traditional IRAs is that you usually have to pay income tax on the dollars you take out and this includes dollars that move to a Roth IRA. So in completing a Roth conversion, you are electing to pay taxes NOW instead of later on (usually in retirement) when you would take the money out. The benefit of this strategy is that the dollars that are now in the Roth grow tax free forever. It does not apply well to everyone and you should talk to a financial advisor to see if it matches your needs.
The backdoor Roth conversion is a more complicated strategy. It involves making a special type of contribution to a Traditional IRA called a non-deductible contribution and then quickly converting those dollars into a Roth IRA. You can see both strategies involve moving money from a Traditional IRA to a Roth IRA which is why both include the idea of a "Roth Conversion", but the backdoor is a bit of a "loophole" in the tax code.
Why Not Just Put Money Into The Roth?
The sensible question when beginning to understand this strategy is why someone wouldn't simply put the money in the Roth IRA to start? Why does anyone need to create more steps by putting it into the Traditional IRA first?
The tax code currently has a provision involving retirement accounts called a "phase-out limit". This limit states that if you make over a certain amount of money (and a few other factors), you are not allowed to put money into the Roth IRA. Anyone is allowed complete a Roth conversion, but not everyone can put money directly into a Roth IRA. This is the exact provision that the backdoor Roth conversion is circumnavigating.
The Catch With Traditional IRA Contributions
Putting money into an IRA gives many people a tax deduction which lowers their tax bill. This is not the case for everyone because the IRS takes that away for people who make over a certain amount of money (another type of phase-out limit). The amount changes most years and depends on various factors including how you file your taxes. If you qualify for the deduction when you put money in an IRA, a backdoor Roth conversion is probably not an ideal strategy for you as you likely want to take the tax deduction you get for putting money in the IRA.
For those who have higher incomes and can't take the tax deduction, you can elect to make a "non-deductible contribution". This means you put money in an IRA but you don't get a tax break. Talk to your accountant or financial advisor about this as you have to file a special tax form to notify the IRS you did this. When you make a non-deductible contribution, you are able to then move that money into a Roth IRA without paying taxes on it.
One More Catch: The Pro Rata Rule
As with many things financial, there are multiple pitfalls that can unravel an entire strategy when not executed properly. The Pro Rate Rule is another example of this and is a little bit confusing to follow.
If you have an existing IRA with pre-tax dollars (old 401K money, contributions you received a tax deduction for, etc) then make non-deductible contributions (as explained above), you must understand the proportion of each before converting to a Roth IRA. This is because the IRS does not allow you to cherry pick the exact non-deductible dollars to convert tax-free. They want all Traditional IRA dollars to be considered when figuring out if and how much you owe in taxes. Take a look at the example below:
Pre-Tax IRA (let's say it was an old 401K) - $95,000, Non-Deductible Contribution - $5,000, Total Value - $100,000
You want to convert the $5,000 from the IRA into your Roth IRA and do so tax-free. Unfortunately, 95% of the account is pre-tax and only 5% is after-tax (non-deductible). If this were the case, then you would be taxed on 95% of the $5,000 you convert to the Roth IRA, or $4,750 would be taxed as income ($5,000 X .95). You are not allowed to pick the $5,000 of non-deductible dollars, you must take a proportional amount of each bucket; deductible and non-deductible.
As you can see, this moderately complex strategy has a lot of what-ifs and potential pitfalls if not executed properly. For those it does work for, it is a strong strategy to get money into a Roth IRA and growing tax-free. Here are some common characteristics for whom this strategy may work best for:
- High earning household making too much to get tax deduction for IRA contributions
- No existing IRAs or very small existing IRAs
- Typically, the younger the better (it still can work for those later in their careers)
- Already maxing out retirement plan(s) through employer
Always consult an advisor before making complex financial moves and to see if a given strategy is in your best interest.