Here are answers to some of the top questions people ask about a backdoor Roth IRA so those considering one can make a well-informed decision.
In this article:
- What Is a Backdoor Roth IRA?
- How Do Backdoor Roth IRAs Work?
- Why Set-up a Backdoor Roth IRA?
- What Is a Mega Backdoor Roth IRA?
- Are Backdoor Roth IRAs Legal?
- How Is a Backdoor Roth IRA Taxed?
- What Is the Backdoor Roth Conversion Pro Rata Rule?
- How Are Backdoor Roth IRAs Reported?
- Can I Do a Backdoor Roth IRA?
- Is a Backdoor Roth IRA a Good Move?
Backdoor Roth IRA | Top Questions Answered
What Is a Backdoor Roth IRA?
A backdoor Roth IRA is an informal name for a strategy and not an official name for a retirement account. It’s a strategy that lets people put money into a Roth IRA even if their income exceeds the IRS-allowed maximum.
For taxpayers with relatively higher income who want to take advantage of the benefits under a Roth IRA, it could prove to be a good option.
How Do Backdoor Roth IRAs Work?
There are two ways a person can contribute to a Roth IRA: contribution and conversion.
When a qualified person puts money directly into his or her Roth IRA account, that’s a contribution. When a person with a Traditional IRA transfers funds from that account to a Roth IRA, that’s a conversion.
Another way to distinguish contribution from conversion within the context of a Roth IRA is this: contribution involves fresh funds or new money while a conversion involves funds that are already in a person’s existing IRA.
A backdoor Roth IRA is a strategy that converts Traditional IRA contributions into a Roth IRA. For the conversion, a person can either open a new Traditional IRA account or just use his or her existing one.
Why Set-up a Backdoor Roth IRA?
One of the best reasons for doing a backdoor Roth IRA is the ability to contribute to a Roth IRA and enjoy its benefits, even if one’s income exceeds the limits set by the IRS. Another good reason to do it is the ability to make tax-free withdrawals from an IRA account.
The IRS taxes Traditional IRA withdrawals but not Roth IRA withdrawals if such withdrawals are within withdrawal rules. This is because Traditional IRA contributions may entitle a taxpayer to tax deductions, unlike Roth IRA contributions.
A backdoor Roth IRA also provides a workaround to two limitations: Roth IRA income and contribution limits.
As of 2019, annual income shouldn’t exceed $137,000 annually for a single person. For a widower or married taxpayers that jointly file their taxes, their maximum annual income should only be $203,000 as of 2019.
Fortunately, these limits don’t apply to Backdoor Roth IRA conversions. So, if a person’s annual income exceeds these limits, he or she can still put money in a Roth IRA via the backdoor.
When it comes to contributions to a Roth IRA, there are limits, too. Beginning in 2019, the maximum amount anyone can contribute directly to a Roth IRA is only $6,000 if younger than 50 years old and $7,000 if 50 years or older.
Backdoor Roth IRA conversions aren’t subject to such limitations because they’re conversions, not contributions. Therefore, a person can put money in a Roth IRA even if the annual income exceeds the income limitations imposed on Roth IRA contributions.
So, if an individual’s income exceeds the limit set for contributing to a Roth IRA, a backdoor IRA can help him or her work around that limit. This is why a backdoor Roth IRA is a good option for high-earning individuals, according to wealth adviser Wyatt Swartz of W. Swartz and Co.
For an individual who wants to build up his or her Roth IRA even more, there’s a more advanced version of the backdoor Roth IRA conversion: the mega backdoor Roth IRA.
What Is a Mega Backdoor Roth IRA?
A mega backdoor Roth IRA is a strategy that allows people who have already maxed out their individual 401(k), IRA, and other tax-advantaged account contributions for the year to put in more money into a Roth IRA. Starting in 2019, the annual contribution limits for retirement accounts are as follows:
- Individual 401(k) pre-tax contribution limit: $19,000.00
- Total 401(k) contribution limit: $56,000.00
- Traditional/Roth IRA contribution limit: $6,000.00
A person can put in as much as $37,000 more into a Roth IRA account annually using a mega backdoor Roth IRA. How?
First, the person must check with his or her 401(k) administrator if the plan allows for non-Roth after-tax contributions, if such contributions are held under a separate sub-account, and if it allows in-service distributions. Unless the plan allows for all three, the mega backdoor Roth isn’t an immediate option.
If both are allowed under the plan, the next step is to compute the 401(k) after-tax contribution opportunity based from the maxed out 401(k) individual contribution. This can be done by subtracting the $19,000 individual pre-tax contribution limit and the employer’s annual contribution from the $56,000 total annual 401(k) contribution limit.
The 401(k) after tax contribution opportunity amount can be maximized at $37,000 if there are no employer contributions, i.e., $56,000 (total annual limit) – $19,000 (individual pre-tax contribution limit) – $0.00 (employer’s contribution) = $37,000. The greater the employer’s contribution, the lower the 401(k) after-tax contribution opportunity amount.
After determining the 401(k) after-tax contribution opportunity amount for the year, the next step is contributing any amount not exceeding the computed 401(k) after-tax contribution opportunity. The last step is rolling over that amount into a personal Roth IRA, tax-free.
Are Backdoor Roth IRAs Legal?
For many years, many retirement planners have debated the legality of the backdoor Roth IRA, particularly from the IRS’ perspective. But Donald Kieffer, Jr., who’s one of the IRS Tax-Exempt and Government Entities Division’s specialists, ended this debate.
In the July 10, 2018 episode of the Tax Talk Today Webcast, Kieffer said that tax laws allow contributions to a Traditional IRA and their subsequent conversion into a Roth IRA. Coming from an IRS official, this effectively put any debate to rest.
How Is a Backdoor Roth IRA Taxed?
Traditional IRAs fall under two major categories: tax-deductible and non-deductible. However, taxes saved on tax-deductible Traditional IRA contributions will come back later when a person withdraws from these contributions.
Deductible IRA Contributions Definition: Traditional IRA contributions which may entitle a person to tax deductions on the year he or she made the contributions. Since such contributions entitle a person to tax deductions on his or her income that funded the contributions, the IRS will impose taxes when a person makes withdrawals from a Traditional IRA account.
Non-Deductible IRA Contributions Definition: Roth IRA and unqualified Traditional IRA contributions which aren’t tax deductible.
Direct contributions to Roth IRAs aren’t tax deductible, which means the IRS has already taxed the income where Roth IRA contributions come from. Because of this, the IRS doesn’t tax qualified withdrawals from Roth IRAs.
When people convert their non-deductible Traditional IRA funds via a backdoor Roth IRA, the IRS doesn’t tax the entire conversion but only the earnings on those contributions. This is because the IRS already taxed the income that funded such contributions.
The IRS taxes the entire amount of withdrawals on tax-deductible Traditional IRAs. This is because it hasn’t yet taxed the income that funded the contributions.
But if the entire IRA account is made up of tax-deductible and non-deductible contributions, then the pro-rata rule will help determine the taxes due on backdoor Roth IRA conversions.
What Is the Backdoor Roth Conversion Pro Rata Rule?
When converting via the backdoor Roth IRA, the IRS considers all IRAs as one single account for purposes of determining tax liabilities, including SIMPLE and SEP IRAs. It considers any withdrawals or conversions to Roth IRA to have a taxable and a non-taxable (tax-free) component.
The IRA determines the taxable percentage of any withdrawal or conversion to Roth IRA based on the percentages of year-end pre-tax (taxable) and after-tax (non-taxable) amounts to year-end totals.
Let’s say a person has three Traditional IRAs containing $60,000 in contributions + earnings (pre-tax), $15,000 in a SEP and SIMPLE IRAs (pre-tax), and $25,000 of non-deductible contributions that have no earnings yet (after-tax), for a total IRA of $100,000. If he or she decides to convert the $25,000 non-deductible contributions to a Roth IRA, the IRS will consider that amount as consisting of both taxable (pre-tax) and non-taxable (after-tax) contributions.
How much of the $25,000 withdrawal will be taxed by the IRS? It will use the pro-rata rule to determine how much of the $25,000 conversion will be taxed.
Only $25,000 of the total $100,000 Traditional IRAs is after-tax or non-taxable. This comprises 25% of the total Traditional IRA balance.
The remaining balance of $75,000 consists of pre-tax or taxable contributions. This comprises 75% of the total Traditional IRA balance.
Based on the percentages given, 75% of the $25,000 Traditional IRA that will be converted to Roth IRA, which means $18,750, will be taxed. This is how the pro-rata rule is applied.
It’s worth noting that the total Traditional IRA balance that will be used for determining the percentages of taxable and non-taxable conversions isn’t the total balance at the time of the conversion. It’s the balance at the end of the year in which the conversion took place.
If there were changes to the total balance between the time of the conversion until the end of that year, then the pro-rata of taxable and non-taxable contributions will change.
In particular, rolling over some of the 401(k) balance to a pre-tax Traditional IRA will result in a bigger pre-tax Traditional IRA balance at the end of the year. A higher proportion of pre-tax or taxable Traditional IRA balances vis-à-vis non-taxable ones at the end of the year can result in higher tax liabilities.
Let’s say that two months after converting $25,000 in Traditional after-tax IRA to Roth IRA, the person rolls over $100,000 of his 401(k) into a pre-tax (taxable) Traditional IRA. Let’s assume further that this was the last transaction of the IRA portfolio for the year.
The year-end balance would change from a total of only $100,000 to $200,000, with the $100,000 increase accounted for under pre-tax or taxable balances. This will grow the pre-tax or taxable balance of the Traditional IRA portfolio from only $75,000 (prior to conversion) to $175,000, which increases the taxable percentage to 87.50% of the $200,000 total.
With a higher taxable percentage, the taxable amount of the $25,000 conversion increases from only $18,750 to $21,875. This is the reason why retirement planners are wary about rolling over 401(k) balances to pre-tax Traditional IRAs during the same year as a backdoor Roth IRA conversion.
How Are Backdoor Roth IRAs Reported?
Taxpayers report conversion-related pro-rata calculations under IRS form 8606, which they file together with income tax returns.
Can I Do a Backdoor Roth IRA?
To be able to do a backdoor Roth IRA conversion, a person must first qualify to make a non-deductible IRA contribution. For this, he or she needs to have earned income in the form of self-employment income or wages.
If a married person files his or her returns jointly with a non-working spouse, they can double their backdoor Roth IRA benefits by having the non-working spouse do a backdoor Roth IRA, too.
For the non-working spouse to qualify, even if they don’t meet the earned income criteria, the working spouse should earn enough income to cover for the non-working spouse’s IRA contributions.
Another qualification is age, i.e., a person shouldn’t be over 70 ½ years old at the time of a backdoor conversion. While Roth IRAs and backdoor ones have no age limits, Traditional IRAs from which backdoor conversion funds come from have such limits.
If a married person jointly files taxes with the spouse, the non-working spouse can’t be over 70 ½ years old. Otherwise, he or she won’t qualify and the working spouse won’t be able to double the backdoor conversion benefits.
Is a Backdoor Roth IRA a Good Move?
One thing to consider when deciding whether to convert a Traditional IRA to a Roth IRA is the tax rate. In particular, a person should decide based on his or her estimated tax rate upon retirement.
If a person strongly believes that his or her tax bracket will be higher after retirement, he or she may consider a backdoor conversion. Tax liabilities can be much lower if the taxpayer pays them now at a lower tax bracket instead of later at a higher one.
However, the backdoor conversion taxes may amount to a huge sum, especially if the balance of the Traditional IRA is already big. Hence, it’s important to weigh the benefits of a backdoor Roth IRA conversion against potential costs, particularly the amount of taxes the person has to pay now.
Another important consideration is liquidity. If the person is younger than 59 ½ years old and strongly believes he or she won’t need to use the converted funds within 5 years, a backdoor Roth IRA conversion can benefit that person.
Liquidity Definition: The ability to pay off financial obligations as they are due. It also refers to how much access to cash one has.
But if that person is younger than 59 ½ years old and has strong reasons to believe that he or she will need the converted funds within the next 5 years, a backdoor conversion may not be worth it. Unless that person is older than 59 ½ years old, he or she will have to pay a 10% penalty fee to withdraw the funds within 5 years.
Finally, a person should consider the need to withdraw from a Traditional IRA at age 70 1/2 or older. This is because, at this age, he or she will have to make mandatory minimum withdrawals from the Traditional IRA, as required by law.
If the person doesn’t need the funds soon, he or she can maximize its earnings by converting them into a Roth IRA. He or she doesn’t need to make regular minimum withdrawals from a Roth IRA, even if older than 70 1/2 years.
With a backdoor Roth IRA, a person can enjoy the benefits of a Roth IRA even if his or her annual income exceeds the IRS-mandated limits. By answering some of the most important questions on backdoor Roth IRAs, anybody can prepare well for retirement by making a well-informed backdoor conversion decision.
Which among the most asked questions on backdoor Roth IRAs do you think is the most important to answer? Do you have other questions you’d like to ask about backdoor Roth IRAs? Let us know in the comments section below.