Financial Planning 101 - Backdoor Roth Conversions
In my previous post, I wrote about Roth conversions. The focus there was on the traditional type of conversion where an investor moves funds from a traditional IRA to a Roth IRA. Today, I will discuss a different type of Roth conversion called the backdoor Roth conversion.
The traditional Roth conversion is suitable and even advisable for a large number of people. The backdoor conversion serves a more narrow audience but can still be a very powerful tool for those in position to take advantage of it. If you try and google a backdoor Roth conversion you will find varying definitions and descriptions. Some will refer to the ‘backdoor’ component as simply converting traditional IRA funds to a Roth which is really just a straight forward Roth conversion that is available to everyone.
The backdoor Roth conversion I will discuss here is a way for high income investors to bypass the income limits on making annual Roth conversions. In my post on Roth IRAs, we discussed the annual limit of contributions of $6,000 for people under age 50 as long as their income is under certain limits, currently $206,000 at the highest, depending upon tax filing status. So while traditional Roth conversions are usually made in bulk sums they don’t address the ability to make annual contributions to a Roth plan for high earners. That’s where the backdoor Roth conversion comes into play.
Why would someone want to do this? While contributing to a Roth in high earning years may not seem to make much sense due to the high taxes you will have paid on the money contributed, think about what your other options are for investments. Assuming you have maxed out your 401k first, where else do you go? A Roth is a better option than a taxable account which has after tax contributions and capital gains taxes on the back end. I also prefer a Roth to any of the tax sheltered insurance related options such as forms of permanent life insurance and annuities.
Here is how it works. Assume your family AGI puts you over the $206,000 threshold for being able to make contributions to a Roth plan. You probably also make too much to make a tax deductible contribution to a traditional IRA. But, you can always make a non-tax deductible to an IRA regardless of your income. So step one is to make that non-deductible IRA contribution. Note, this will be after tax money. Step two, convert this non-deductible IRA amount to your Roth account.
So, what are the benefits?
This allows a high earner to make annual Roth contributions. No tax owed on the conversion since it was taxed before entering the IRA.
Enjoy tax free growth on the converted amount.
Provides tax flexibility by allowing a high earner to have not just tax deferred income in retirement.
Sounds great, let’s do it! To quote the great Lee Corso, “Not so fast my friend.” There are some major strings tied to the backdoor conversion you need to be aware of before trying one and they are significant.
Annual limit on the contribution limit. IRA contributions are limited to $6,000 per year for people under age 50 and $7,000 for those 50 and above. So, for a high earner this can be a somewhat complicated process to go through for a $6,000 contribution. But, that tax free growth can be worth it.
Pro-rata rule. This is the big one and can frankly make this a non-starter for some people. The pro-rata rule states that when making a Roth conversion you must make the conversion in the same ratio as what you have in pre-tax vs after-tax money in your IRA. For example, let’s say you have $54,000 in an IRA from a 401k rollover. You now have added you $6,000 after tax contribution and try to do a $6,000 Roth conversion. That leaves you with an IRA balance of $60,000 (90% of which is pre-tax and 10% after tax). The pro-rata rule prohibits you from cherry picking that specific after tax $6,000 for conversion. Instead, your $6,000 conversion is going to be made up of $5,400 pre-tax and just $600 of that after tax contribution. Since 10% of your IRA balance is made up of after tax contributions you are limited to 10% of the converted amount to be after tax. This can be a deal breaker for those that already have large established IRA balances as you will have to recognize the income and pay taxes on the non after tax amount and may only be able to convert a small potion of your after tax contribution.
Taxes owed on gains. If there is a lag between the time the after tax contribution is made and the conversion takes place, the principal that was contributed may have gains associated with it. These gains will be considered ordinary income when converted along with their principal.
So who should be trying to take advantage of the backdoor Roth conversion? This conversion makes sense for people meeting the following criteria:
High income earners
Maxed out their 401k and still have funds to invest
No previous IRA balance
The limitations due to the smaller amounts that are converted and the specific criteria needed to be met for the conversion to be beneficial make this an option that a limited number of people can take advantage of. While the backdoor conversion may not be quite as powerful a tool as traditional Roth conversions due to these limitations, it is still an option for high earners that allows access to annual Roth contributions they would otherwise be prohibited from making and there can be significant value in that.
That wraps up our overview of backdoor Roth conversions. I hope you found this informative and helpful for your understanding of personal finances. As always, if you are wondering if this makes sense for you and your specific circumstances please reach out to me at firstname.lastname@example.org or check out our website at www.7thstfinancial.com and provide your contact information.
Thank you for reading and I hope you check out our next topic which will be on one final type of Roth conversion, the Mega Backdoor Roth Conversion.
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