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- Backdoor Roth IRA
In this article, we’ll cover…
The steps to do a Roth conversion
The tax implications and rules for conversions
The timing of when to do a Roth conversion
A backdoor Roth, or a Roth conversion, is a strategy that allows you to convert a traditional IRA into a Roth IRA. Your eligibility to contribute to a Roth IRA is based on your income level - if filing as a single person, your modified adjusted gross income must be under $140,000 for 2021 and under $144,000 for 2022. If you’re married and filing your tax return jointly, your modified adjusted gross income must be under $208,000 for 2021 and $214,000 for 2022.
The maximum you can contribute to all IRAs in a given year is:
$6,000 if you’re under age 50
$7,000 if you’re age 50 or older
So, if you want to put money into a Roth IRA but earn too much, you can use the “backdoor” Roth IRA strategy.
Steps to do a Roth Conversion
Put money in a traditional IRA account. If you don’t already have a traditional IRA account, you will need to open an account and fund it.
Pay taxes on your IRA contributions and gains. Only post-tax dollars get to go into Roth IRAs. So if you deducted your traditional IRA contributions, you’ll need to give that tax deduction back, effectively. Those IRA contributions, and any investment gains, will be added to your taxable income when you file your tax return for the year.
Convert the account to a Roth IRA. If you don’t already have a Roth IRA, you’ll open a new account during the conversion. Your IRA administrator will give you the instructions and paperwork.
In order to abide by tax rules, choose one of the following ways to do the conversion:
Indirect rollover. You receive a distribution from a traditional IRA and contribute it to a Roth IRA within 60 days.
Trustee-to-trustee or direct rollover. You tell the financial institution holding your traditional assets to transfer an amount directly to the trustee of your Roth IRA at a different financial institution.
Same trustee transfer. If your traditional and Roth IRAs are maintained at the same financial institution, you can tell the trustee to transfer an amount from your traditional IRA to your Roth IRA.
Tax Implications and Rules for Conversions
Many retirement savers are unaware of the tax implications that such a process can trigger. Roth IRAs are funded using after-tax dollars, so many assume that moving tax-deferred money to a Roth IRA means you will pay taxes on the amount to be converted and that’s it. Unfortunately, that’s only true if you have never contributed non-deductible, or after-tax, money to a traditional IRA.
If you have no other IRAs, figuring out your tax due will be simple.
However, it can be more complicated if you have other IRAs. The IRS’ pro-rata rule requires you to include all of your traditional IRA assets - that means your IRAs funded with pretax (deductible) contributions as well as those funded with after-tax (nondeductible) contributions - when figuring the conversion’s taxes. This is known as the IRS’ aggregation rule - no IRA stands alone, all IRAs are considered in the aggregate. To prevent people from skirting the Roth income limit and manipulating funds to lower their tax bill, you are not allowed to choose which funds you convert. Then, you pay a proportional amount of taxes on the original account’s pretax contributions and earnings. Let’s look at an example:
I am finishing a career that I anticipate will land me a job with a salary that will launch me into the next income tax bracket, so I decide to convert my traditional IRA into a Roth IRA.
I have $100,000 in a traditional IRA, $7,000 of those dollars came from funds that were already taxed (non-deductible contributions). Because I’ve already paid taxes on the $7,000, the IRS will not require me to pay taxes on that amount again, or twice. But, the IRS will also not allow me to decide that my Roth conversion will only use those after-tax funds, the $7,000.
If I want to convert the $7,000 to a Roth IRA, I’ll need to calculate how much of my IRA funds are actually taxable. The IRS aggregate rule requires me to include the value of all my non-Roth IRAs as the basis. Here’s how the math looks:
$7,000/$100,000 = 0.07 → 7% of my total IRA value is non taxable since I already paid taxes on that $7,000. But if I want to convert $7,000 to a Roth IRA, the converted amount comes from 93% pre-tax funds and only 7% after tax funds. I’ll have to pay taxes on 93%, or $6,510, of the converted amount [$93,000 x 7% = $6,510]. That means $6,510 of the original non-deductible $7,000 is still in the traditional IRA, and any future after-tax contributions to my non-Roth IRAs will further complicate my pro-rata percentage.
It’s also important to note that once the funds are converted, you must wait 5 years before withdrawing any of the funds. If you can’t wait, and you withdraw funds, you’ll face a 10% penalty.
Timing your Roth conversion
The benefits of Roth IRAs can be huge, but the price to create a backdoor Roth IRA can be steep. Funds directed to Roth IRAs are taxed at the time of contribution, not at the time of withdrawal. The timing of the tax means that making a big contribution all at once can mean that there is abruptly a large chunk of money on which you owe taxes.
If you have a significant balance in your traditional IRA, you may want to carry out multiple Roth IRA conversions over several years. If done properly, a multiyear approach can allow you to convert a large portion of your savings to a Roth IRA while limiting the tax impact. Early in retirement - when your earned income drops but before required minimum distributions kick in - can be an especially good time to implement this strategy.
Be sure to consult a financial advisor if you are considering making a Roth conversion when you are within two years of filing for Medicare and Social Security.