Backdoor ROTH IRA

Is A Backdoor Roth IRA A Good Move?

in Retirement Planning by

Are you interested in reducing your taxes as much as possible?

Does your current income make you ineligible to contribute to a Roth IRA this year? (if you’re a married couple, you’re ineligible if you jointly make over $191,000, if you’re single, you’re ineligible if you make over $129,000)

Do you feel taxes will be higher in the future?

If you answered “yes” to any of these three questions, it may be worth your while to consider a backdoor Roth IRA.

With a Roth account, not only do you allow your hard earned money to grow tax-free, but you also withdraw those funds tax-free in retirement (NB: don’t forget, you do pay tax upfront in that you contribute with after-tax dollars). On the other hand, in practice, the backdoor Roth IRA comes with its limits– and complications.  As such, it doesn’t always beat other retirement savings account options.

In this post, I review the backdoor Roth IRA process and illustrate why they’ve become popular since 2010, when income limits for Roth conversions were removed.  I then review the limitations and drawbacks of backdoor Roths to help readers decide whether this path may be worth pursuing.

WHAT IS A BACKDOOR ROTH IRA?

Two Step Process For Creating a Backdoor Roth IRA:

Step 1: Contribute to a (nondeductible) traditional IRA. Unlike a Roth IRA, the traditional IRA has no income ceiling for contributors.

Step 2: After the funds clear, convert the traditional IRA to a Roth IRA in order to never pay taxes again on your investments.  Since no time has elapsed, there are no earnings on those funds and it’s a non-taxable event (unlike if you were to convert a deductible IRA into a Roth, in which case you pay an upfront tax at your current rate).

A backdoor Roth IRA is a solution for investors who make too much income to qualify for normal Roth contributions, and want to increase their retirement savings in tax advantaged accounts. Specifically, this is an additional retirement saving alternative for investors who have maxed out the $17,500 (with $5,000 additional catch up contributions for those over age 50) allowable contribution limit for workplace retirement plans and want to contribute more to a tax advantaged retirement account.

In general, it’s a good idea to contribute the maximum allowable by law to your workplace retirement account before creating a backdoor Roth IRA (see the Daily Capital post, Retirement Savings: Start with Your 401k for more detail). And if you decide to contribute to a backdoor Roth for multiple years, the process must be repeated each year and can’t be automated.

For example, Fauzia is a single 40 year old senior engineer who earns $127,999 per year who contributes $17,500, pre-tax to her workplace 401k. Fauzia would like to increase her retirement contributions and implements the backdoor Roth strategy. She opens a traditional IRA and contributes $5,500 of after-tax dollars. After the money clears, she instructs the IRA administrator to convert the contribution to the traditional IRA to a Roth IRA. Unless there was a change in the value of the assets in the short time, she doesn’t have to pay any additional taxes – and thus has effectively set up a Roth even though she exceeds the income limits. Fauzia legally contributed $23,000 to her retirement savings which will grow tax free.

ROTH IRA Income Contribution Limits

BENEFITS OF A ROTH IRA

The main tax benefits of a Roth are that any money (contributed after tax) grows tax-free and is withdrawn without any further taxation. Further, unlike a traditional IRA, there are no required minimum distributions and the Roth IRA can be passed on to one’s heirs. This allows the funds to grow tax free over many years, and offers tax-free compounding and withdrawals (Here’s a quick primer on the Roth IRA benefits if you’d like to read more).

For example, Javier is age 40 and contributes $5,000 to a backdoor Roth and invests in a diversified portfolio of stock and bond funds with an average annual return of 7%. This contribution could grow and compound for as long as he desires. He never needs to take the money out of the account and can pass it on to his heirs. Consider the power of compounding over time; at age 70, the $5,000 contribution made 30 years ago with no additional contributions is worth ~$38,000.

Had Javier left the money in a nondeductible traditional IRA, the original contribution would still be worth $38,000 by the time he’s 70. However, Javier would have to begin withdrawing by the end of the year.  He can either withdraw the entire amount or at minimum, the “required minimum distribution” (the market value divided by the applicable life expectancy factor, which ends up being ~3% for a 70-year-old and 15% for a 100-year old) .  Further, he’d have to pay tax on those distributions.  As you can see in Javier’s case, the backdoor Roth was clearly preferable to the nondeductible traditional IRA.

So for readers: is it time to call your advisor to get started on a backdoor Roth?  Not so fast.  It turns out that the above examples are overly simplified.  In reality, the backdoor Roth has complications that make it less appealing than it might appear on the surface.  In the following sections, I outline the factors that should make you pause – or halt – when considering a backdoor Roth IRA.

 WHO DOESN’T NEED A BACKDOOR ROTH IRA?

1) If you are satisfied with the maximum retirement limit through your workplace retirement account (401k contributions are pre-tax are often accompanied by an employer match – making them the optimal retirement savings vehicle in most cases) and are not planning on additional retirement savings, you don’t need a back door Roth IRA.

2) If you already have money in a traditional IRA, because of the pro rata rule (read on to the next section to learn about this rule) it may not up being advantageous from a tax perspective to convert.

3) If you are unwilling to keep the funds in the newly created Roth IRA for at least five years before withdrawing the money. Because a backdoor Roth is considered a conversion and not a contribution, the funds will incur a 10 percent penalty if withdrawn within five years unless you are age 59 ½ or older.

4) If you are in a high tax bracket now and expect to be in a lower tax bracket upon retirement, you may want to keep the money in the traditional IRA.

5) If you plan to relocate to a lower income tax state or a state where there are no income taxes (Texas, Wyoming, Nevada, Alaska, Florida, Washington, and South Dakota).

6) If you are over than age 70 ½ you’re ineligible to contribute to an IRA and thus can’t utilize the back door Roth IRA strategy.

BEWARE OF THE PRO RATA RULE 

The pro rata rule is the main complication of the Roth – even if it otherwise sounds like it might be for you. How it works: if you have any other deductible IRAs (for instance, an old 401k that you’ve rolled over), the conversion of any contributions becomes a taxable event that you’ll need to pay taxes on upfront.

But wait, didn’t we say that because any contribution to a backdoor Roth comes from an immediate conversion from a nondeductible IRA, it’s a nontaxable event?  Yes, but there’s a big exception: if you own any deductible IRAs.  In that case, you are taxed upfront on the pro rata amount of the conversion (the conversion value divided by your entire IRA value) that was deductible.  This may sound complicated, I’ll help walk you through this tax issue in an example.

Assume Michelle has $95,000 of IRA money spread out in various accounts. Even though these are in separate accounts, the IRS considers them as one IRA. Michelle then contributes $5,000 into a non deductible traditional IRA, and soon after transfers that $5,000 into a Roth IRA, utilizing the backdoor Roth strategy.

If Michelle had no other IRAs, the conversion to the Roth IRA would be tax-free.  Since Michelle has other IRA assets, this is not the case.

The pro rata rule requires Michelle to consider all of her IRA money that hasn’t been taxed yet and views the $5,000 as a percent of the total IRA pool of (non taxed) funds. The $5,000 converted to a Roth is considered 5% of her total IRA assets ($5,000/$100,000).  Her percentage of deductible funds in her IRA is therefore 95%, and upon conversion she owes a tax upfront on $4,750.  As you can see, the backdoor Roth picture is quite different here and in most cases should be advised against.

IS A BACKDOOR ROTH IRA FOR YOU?

Given all of the benefits outlined, Backdoor Roth IRAs are certainly something to consider when you’re charting out your retirement savings.  Namely, if you’ve already maxed out other retirement savings options, you’re willing to leave the money in the Roth for at least five years, and you expect to be in a higher tax bracket in retirement, it’s something to consider.

However, Backdoor Roth’s are not for everyone, so if you do consider it – chart your course carefully. If you already have traditional IRA or have room in other retirement savings vehicles, make sure to do the math to see if this is for you.  You can always reach out to a Personal Capital Financial Advisor to discuss the pros and cons of this strategy and how it applies to your own situation. Or you can simply sign up to use Personal Capital’s free Financial Dashboard to track your finances.

Request to speak with a Personal Capital Advisor today

Readers, have you considered doing a backdoor Roth IRA? Who is most suitable for doing a backdoor Roth IRA? Do you will pay more taxes in retirement than when working?

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Barbara Friedberg
Barbara Friedberg, MBA, MS is an investment portfolio manager, former university finance instructor, and website publisher at Barbara Friedberg Personal Finance.com. Her recent book, "How to Get Rich; Without Winning the Lottery", is available on Amazon. Barbara excels at teaching wealth building through investing. You can follow her on Twitter at @barbfriedberg

18 comments

  1. Financial Samurai

    I’ve gotta say Barbara, I’m coming around to the backdoor ROTH because it feels like something that the government does not want people making over $129,000 and $191,000 to do. Just because there is this loophole, I’m on board!

    Reply
  2. Barbara Friedberg

    @Financial, the opportunity to shelter as much of your income from taxes while it grows is one of the best money deals there is. As long as there’s a backdoor…. I say, why not walk through it?

    Reply
    • Financial Samurai

      True. The biggest thing is: How many people actually make more in retirement than when they work?

      Not many, is the answer. But, regardless, I’m writing a post on my site for this week which highlights the merits of this post b/c I do see the benefits.

      Reply
  3. John @ Frugal Rules

    Great breakdown Barbara! I started seeing these pop up when I was still in the industry in 2010 and if you can swing it, it can be quite nice. Like you said though, the Pro Rata rule is a sticking point, I saw it trip up a number of people.

    Reply
  4. Smart Saving

    This is an excellent explanation of the pro rata rule, which can be very confusing. Thanks Barbara!

    It’s too bad the IRS has made tax advantaged retirement savings so complicated. The pro rata rule in particular seems to penalize people who are responsibly and actively saving for retirement — folks who already have a deductible IRA and are trying to use every tax advantaged retirement savings vehicle available. The IRS is essentially penalizing responsible savers!

    Reply
  5. I think I found a small error. In the Fauzia example, it states she “legally contributed $23,000 to her retirement savings which will grow tax free and which she can withdraw tax-free.”

    Part of that $23,000 was $17,500 in her 401(k). Thus, on that portion and it’s earnings, she won’t be able to “withdraw tax-free.”

    In any case, a couple of questions:

    1) Is there no limit to how many traditional-to-ROTH conversions you can do? Just once per year?

    2) For the Pro Rate Rule to apply, the already existing IRAs must have been deductible, right? So, in the example, if the $95,000 were in non-deductible IRAs, then the conversion would be a non-taxable event, correct?

    Reply
  6. Barbara Friedberg

    Barbara Friedberg

    @John, The prorata rule is quite cumbersome. I think that can be a sticking point. That is an aspect of the Backdoor Roth which should probably be reviewed with a professional in most cases.

    Reply
  7. Barbara Friedberg

    Barbara Friedberg

    @Mr. Utopia,

    Thanks for the Fauzia typo, it’s being taken care of!
    1)The issue with the number of conversions is influenced by the dollar contribution to a traditional IRAFor 2013-14 the total amount one is allowed to contribute to a Traditional IRA within one year is $5,500 ($6,500 if you’re age 50 or older).
    2)Yes, you are corect wrt to the Pro Rata Rule. See this section in the article; ” Yes, but there’s a big exception: if you own any deductible IRAs. In that case, you are taxed upfront on the pro rata amount of the conversion (the conversion value divided by your entire IRA value) that was deductible.”

    It is quite complicated isn’t it?

    Reply
  8. Steve

    I’ve never understood #4 4) If you are in a high tax bracket now and expect to be in a lower tax bracket upon retirement, you may want to keep the money in the traditional IRA.

    If the traditional IRA is not deductible ( which it wouldn’t be if you are doing a backdoor IRA ), zero taxes incurred on a Roth withdrawal, will always be a better deal than the taxes on a withdrawal from a traditional IRA.

    Reply
  9. Barbara Friedberg

    Hi Steve,
    Thank you for mentioning this important point.
    You are correct that in the case of the back door Roth, since the contributions are post tax, the zero tax due upon withdrawal, along with the lack of RMD and the opportunity to pass the Roth on to heirs makes this an excellent retirement vehicle. (The tax bracket in retirement is a moot point)

    Reply
  10. Kool73

    A way around the pro rata. From the above example of a pre-existing traditional IRA of $95,000. If you can, transfer your IRA into your 401k if it has low costs and good choices. (I have the TSP, which is excellent). You pay no taxes with this move and now have $0 in your IRA. Now, any contributions to your IRA will already be taxed and you can have a tax-free Roth IRA conversion. Not bad!

    Reply
  11. Phil in AZ

    Thanks for the report. However for high income married couples with a one salary earner who is covered by a 401k and has IRA assets already, you missed a point that could help your readers. The spousal IRA. I have opened and funded a spousal IRA and then done the backdoor roth IRA since the income limitations were removed. It has allowed us as a married couple to increase our long term tax free retirement assets and is now a key part of our financial planning. Perhaps you can comment on this approach too

    Reply
    • Financial Samurai

      This is why I open up my post to comments. Feel free to help explain further any loopholes or benefits of the spousal IRA and how that doesn’t pertain to others. thx

      Reply
  12. Barbara Friedberg

    Barbara Friedberg

    @Kool, When transferring a Traditional IRA to a Roth can be a good strategy. When the contributions were made to the traditional IRA with after tax dollars, there won’t be tax due with the conversion. That’s not the case with a traditional IRA with pre tax contributions. Thanks for the insights.
    @Phil-The spousal IRA is a must for any non working spouse if you can swing it. Thanks for mentioning it.

    Reply
  13. buckeye Investor

    Can I move my rollover IRA to my company 401-K so I don’t have the Pro Rata issue. And if I do move the money to my company 401-K how long do I have to wait before I can take it back out and put it back into a rollover IRA without an IRA issue?

    Reply
  14. Popat

    Very insightful discussion!

    My wife currently has a Rollover IRA, but would like to take advantage of a backdoor IRA. Based on what everyone has said here, it seems all I need to do convert the Rollover IRA to a Roth, pay the tax (there’s only a small amount in there), open a non-deductible IRA at the same brokerage, and then deposit money and convert/transfer it over to the new Roth IRA acct. This should eliminate the pro-rate issue. Is that correct?

    Also – what is the timeframe associated with this? Does this have to be completed by Dec 31 of this year or can this be done anytime through Apr 2015?

    Reply
  15. Barbara M.

    Thank you for your article. I have a question – the pro rata rule only applies to Traditonal IRAs I own at the time of the backdoor conversion, correct? I did a backdoor conversion earlier this year with no other traditional IRAs. Then I had to convert my 401k to a traditional IRA, so now I do own a traditional IRA and want to avoid the pro rate rule. I won’t owe the penalty since I didn’t have the trad IRA at the time of the conversion, correct? Thank you!

    Reply

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