Roth IRAs are a great way to grow your money tax-free. However, once you reach a certain income level, you are likely no longer eligible to contribute to a Roth IRA. Luckily, you might be able to take advantage of a tax loophole that came about in 2010 called a Backdoor Roth IRA.
What is a Backdoor Roth IRA?
A backdoor Roth is a way to accumulate money in a Roth even if you’re no longer eligible to contribute to a Roth IRA. First, you start off by contributing money to a traditional IRA. Then you do a backdoor Roth conversion to a Roth IRA. You pay taxes on the earnings (not the contributions). Then your investments can grow tax-free and you can make tax-free withdrawals later. It’s completely legal and very simple!
How does a Backdoor Roth IRA work?
Below are the three steps to do a backdoor Roth IRA strategy.
Step One: Contribute to a Traditional IRA.
This is pretty straightforward. You can do this through any brokerage firm (Vanguard, Fidelity, etc) as this choice is of no significant impact. You have the option of making the maximum contribution for that year ($6,000 in 2022; $7,000 if you’re age 50 or older).
It is crucial to remember that you likely do not want to deduct this contribution from your tax return. If you’re no longer eligible for a Roth, you most likely are also not eligible for a traditional IRA deduction. This is the primary reason people call it a non-deductible traditional IRA.
Step Two: Move your pre-tax IRAs to your current employer plan.
Many people willingly neglect this step, which can lead to a huge tax bill. If you have a rollover IRA that came from an old employer plan (401(k), SEP IRA, etc), it is time to move these to your current employer retirement plan. You may be wondering what that has to do with a backdoor Roth IRA. It has to do with the IRS aggregation rule.
Example: Let’s say you have $95,000 in a rollover IRA. Congratulations on saving that much from your previous job! Now let’s assume you just contributed $5,000 into your new non-deductible traditional IRA. You now have a total of $100,000 in traditional IRA money, 5% of which represents your non-deductible IRA, and 95% of which represents previously tax-deducted contributions. Now, if you do a Roth conversion of that $5,000 (you convert this money from traditional to Roth), the IRS will treat it as if you just converted part of your rollover IRA. So, in this example, you just converted 5% of your total IRA money, most of which was tax-deductible when you contributed, so when you convert to Roth, the IRS wants their cut. This could generate an unnecessary tax bill, which we obviously don’t want.
So, consider moving your pre-tax IRAs into your current 401(k) (or another current employer plan). Every employer plan handles this process slightly differently, so you could start by calling your current employer plan company to get the necessary paperwork to start the rollover process.
Step three: Convert your traditional IRA to a Roth IRA
We recommend you consider doing this step at least 12 months from when you contribute to your IRA. The reason for this is because the U.S. Tax Court follows a rule called the Step-Transaction Doctrine, which sounds really boring. Essentially this doctrine says that if you do all of these steps consecutively (contribute to a Traditional IRA, and then you convert it to a Roth the next day), they will see it as one single transaction. In this case, that would mean you are contributing to a Roth IRA when you are no longer allowed to, and they will slap a penalty on this transaction. You don’t want to risk that! This 12-month rule is not a hard and fast rule. Some advisors think that waiting one month is sufficient, so this is really up to you.
While waiting to do the backdoor Roth conversion, it is best to invest that money, say in stock funds or bond funds.
Doing the Roth conversion can be really simple. In Vanguard, for example, there is a button that says “convert to Roth IRA.” So, you just click on that and follow the instructions. In Fidelity, you have to do some searching. Every brokerage firm will handle it slightly differently, but it should not be an overly difficult process.
Now, when asked about tax withholding, you can choose to not withhold taxes so you have more money going into your Roth IRA when you convert. Once you complete the conversion process, you now have a Roth IRA! You can simply repeat these three steps each year to continue growing tax-free retirement money.
Is backdoor Roth legal?
Yes, it’s been legal since 2010. However, there is a bill pending in the US Senate to ban it. This bill has not yet passed.
Who is eligible for a Backdoor Roth IRA?
Anyone can do a backdoor Roth IRA, while the proposed bill to ban it has not been passed. However, there are potential pitfalls in executing the backdoor Roth, so make sure you do it correctly. If you’re still eligible to contribute to a Roth, it is not necessary to do a backdoor Roth IRA.
Can I do a backdoor Roth every year?
Yes, you can do a backdoor Roth IRA contribution and a backdoor Roth conversion every year. The contribution limit for 2022 is $6,000 ($7,000 if you’re age 50 or older). This is the entire amount that you can put into all of your IRAs combined. However, in September 2021, the House Democrats proposed several changes to retirement plans. One of these proposed changes is prohibiting the conversion of an after-tax IRA to a Roth IRA. This would eliminate the backdoor Roth IRA strategy. The Senate has not passed an equivalent bill.
When should I contribute to a Backdoor Roth?
It’s typically best to do the contribution and backdoor Roth conversion in the same calendar year. Basically, you can contribute to a Traditional IRA early in the year, invest that money, then do the backdoor Roth conversion towards the end of the year.
Is backdoor Roth still allowed in 2022?
Yes, backdoor Roth IRAs are still allowed in 2022. However, if the proposed legislative changes are passed, then the backdoor Roth strategy will be eliminated.
Will backdoor Roth be eliminated?
If the Build Back Better Act is passed by the Senate as it is, then the backdoor Roth will be eliminated. However, the chance of this happening is currently very low.
Who should consider a backdoor Roth?
If you are already maxing out your 401(k), you still have excess cash to invest, and you are no longer eligible to contribute to a Roth, then you can consider doing a backdoor Roth.
Who might not benefit from a Backdoor Roth?
If you’re fully eligible to contribute to a Roth, then you don’t have to do a backdoor Roth. If you have a high-interest consumer loan, you may want to pay that off first before doing a backdoor Roth. If you have a lot of cash but need it for a house down payment in the next year or two, then you may not want to tie that up in a backdoor Roth.
Is a backdoor Roth the same as a Roth conversion?
The backdoor Roth is the name of the strategy. Roth conversion is the third step in executing the backdoor Roth strategy.
What is the pro rata rule for Roth conversion?
The pro rata rule means that if you have both a non-deductible and a pre-tax IRA, then doing a Roth conversion will result in a tax bill. That’s because the IRS will treat a percentage of your conversion as coming from your pre-tax IRA.
How much money can you convert from a traditional IRA to a Roth IRA?
There is no limit on how much money you can convert from a Traditional IRA to a Roth IRA. You just have to pay attention to the potential tax implications of this conversion.
Can I have 2 Roth accounts?
You can have 2 Roth accounts at the same or different institution. However, your total IRA contribution across all your IRA accounts must still be $6,000 for 2022 ($7,000 for age 50 and older).
How to fix backdoor Roth IRA mistakes
Mistake #1: Contributing directly to a Roth IRA when you’re not eligible. To fix this, you can either fill out an excess contribution form or recharacterize your Roth IRA contribution to a Traditional IRA.
Mistake #2: Forgetting to invest your Traditional IRA contribution. This is a common mistake. If you contribute to a Traditional IRA then do an immediate backdoor Roth conversion, it might be seen as a red flag by the IRS. If your contribution has been sitting in a money market fund, you can consider investing it in a diversified fund before doing the backdoor Roth conversion.
Mistake #3: Forgetting to do the Roth conversion. This is an easy one to fix. You can just go ahead and do the Roth conversion. The downside of having waited so long to convert is you will likely owe more taxes upon the Roth conversion, if your Traditional IRA investments have gone up. Remember, you have to pay taxes on the earnings (not the contributions).
Mistake #4: Forgetting to move your pre-tax IRAs. This can be a costly mistake. If you convert your non-deductible Traditional IRA while you have a pre-tax IRA (e.g. SEP or Rollover IRA), then it will trigger the IRS pro-rata rule. You will end up with a higher tax bill, since the IRS will view it as you having converted part of the pre-tax IRA to a Roth. Fixing this mistake is difficult.
Pros and cons of a backdoor Roth
Pros: It can allow you to grow your money tax-free, even if you are a high-income earner.
Cons: Executing a backdoor Roth properly involves a series of steps. If you make one mistake, you might end up with a higher tax bill.
Backdoor Roth IRA tax implications
When you convert your Traditional IRA to a Roth, you will owe ordinary income taxes on the earnings. Say you contributed $6,000 to a Traditional IRA, and after investing the money it grew to $6,600 by the time you did a backdoor Roth conversion. You will owe federal and possibly state taxes on the $600 of earnings.
How do I avoid taxes on a Roth IRA conversion?
You may be able to avoid taxes if you do your backdoor Roth conversion while the stock market is down. If you do the backdoor Roth IRA conversion when the value of your investments in your Traditional IRA is below the contribution amount, then the conversion generates a taxable loss. This can lower your taxable income.
Do you pay taxes twice on backdoor Roth IRA?
If you have earnings in your Traditional IRA when you do the backdoor Roth conversion, then you have to pay taxes on the earnings. When you withdraw money in your backdoor Roth IRA after 59.5 years old and after the five-year holding period, then no taxes are due.
Does the 5 year rule apply to Roth conversions?
The 5 year rule applies to Roth conversions. This means that you have to wait for 5 years before you can withdraw earnings tax-free from your backdoor Roth IRA. Note that you also have to be at least 59.5 years old.
Do you pay a 10% penalty on Roth conversions?
If you withdraw from your backdoor Roth before age 59.5 years old and before the 5 year holding period, then you typically pay a 10% penalty. You may be exempt from this 10% penalty if the withdrawal is for a first-time home purchase, college expenses, and birth or adoption expenses.
Is a Backdoor Roth worth it?
If you want to save tens of thousands of tax dollars, then it may be worth your time learning how to do a backdoor Roth properly. If you save $6,000 a year for 30 years through a backdoor Roth and grow your money by an average of 6% per year, you can potentially generate close to $300,000 in tax-free money!
What is a mega backdoor Roth?
A mega backdoor Roth is a retirement savings strategy that could allow you to put up to $40,500 in a Roth 401(k) in 2022, on top of your regular $20,500 annual contribution. It is basically the supersized version of the backdoor Roth IRA. The mega backdoor Roth strategy will also be eliminated if the bill proposed by the House is passed by the Senate. Creating a mega backdoor Roth is complicated. It is best to consult a certified financial planner if you want to do a mega backdoor Roth for 2022.
Can you do backdoor Roth and mega backdoor Roth?
Yes, you can do a backdoor Roth and a mega backdoor Roth at the same time. To do a mega backdoor Roth, you need to have access to a 401(k) that allows after-tax contributions, and an in-plan Roth conversion option.
Bonus backdoor Roth IRA tip:
You might be tempted to brag about creating a Backdoor Roth IRA with your CPA or your parents or your friends. You might not want to mention the word Backdoor Roth IRA in your email or text messages. This is again because of that Step-transaction Doctrine we discussed earlier.
Implement a backdoor Roth IRA strategy today!
If you want to make sure you’re doing the backdoor Roth IRA strategy correctly and are also interested in a comprehensive financial plan, we’ll be happy to help you. You can schedule a free discovery call with any financial advisor on our team.
Alvin Carlos, CFP®, CFA is an investment advisor and fee-only financial planner, in Washington, D.C that works with clients across the country. He has a Master’s degree in International Relations from SAIS-Johns Hopkins. Alvin is a partner of District Capital, a financial planning firm designed to help professionals in their 30s and 40s achieve their financial goals through smart investing, reducing taxes, retirement planning, and maximizing their money. Schedule a free discovery call to learn how we can help elevate your finances.