The Backdoor Roth—Is It Right for You?

Backdoor Roth IRA Pitfall #1: An Unexpected Tax Bill

The allure of the backdoor Roth IRA is the potential to complete the transaction and avoid any additional taxes you’d face in retirement if you put the money in a traditional IRA. But if you don’t take into account all of your existing IRAs, you might end up with an unexpected tax bill.

Two facts to keep in mind: Non-deductible contributions are made with money that’s already been taxed. And when you convert a traditional IRA to a Roth IRA, you owe a bill to Uncle Sam on any money that hasn’t been taxed yet. Practically speaking, you can avoid this as long as you don’t invest the money when you put it into your IRA and then you convert it to a Roth quickly.

Here’s the big honking catch, though: If you have pre-tax money sitting in any other traditional IRA accounts, your backdoor Roth conversion will trigger a tax bill, courtesy of the IRS’ pro-rata rule.

The Pro-Rata Rule and Backdoor Roth Conversions

For tax purposes, the IRS considers all your (seemingly separate) IRAs as one big account. The pro-rata rule boils down to the percentage of your total combined IRA balances that has yet to be taxed. Whatever that percentage is determines the percentage of your backdoor Roth IRA conversion that will be taxed.

For example, let’s say you have $94,000 in existing traditional IRAs that were funded with pre-tax dollars. And now you contribute $6,000 to a new traditional IRA with after-tax dollars, then immediately convert that $6,000 to a Roth via the backdoor Roth IRA strategy.

As far as the IRS is concerned, you now have $100,000 in traditional IRAs, and the $6,000 you are contributing with after-tax dollars represents 6% of your total. That means only $360 of your $6,000 backdoor conversion is tax-free (6% of $6,000). You owe income tax on the other $5,640 you backdoored.

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Can I Withdraw the Amount of My Conversion Without Taxes or Penalties?

In general, you are able at any time to take a tax-free distribution of funds that you’ve contributed to a Roth individual retirement account (Roth IRA). However, if the funds are in your Roth IRA due to a conversion from a traditional IRA, you must wait five years before you can take a penalty-free distribution of your contributed funds. This five-year rule applies to every conversion, individually.

There is a reason for this exception to the tax- and penalty-free rule. The Internal Revenue Service (IRS) realized that taxpayers could use the Roth IRA conversion as a loophole to take early distributions penalty-free. For example, let’s assume a taxpayer has $50,000 in their traditional IRA. They could convert the funds to a Roth IRA, pay the required taxes, and take the funds out of the Roth IRA the next day. To close this loophole, the IRS set a special rule about funds from Roth IRA conversions.

Is a Backdoor Roth IRA Worth It?

Depending on several factors, the Backdoor Roth Conversion may not fit everyone’s financial strategies and goals. For example:

  • You may not need a Backdoor Roth Conversion if you are able to meet your savings goals with the maximum retirement limit through your workplace retirement account and are not expecting a need for additional savings for your retirement plan.
  • If you already have pre-tax money in a traditional IRA, because of the pro rata rule, it may not end up being advantageous from a tax perspective to convert.
  • It’s worth noting that inherited IRAs are not included in the pro rata calculation.
  • You should be willing to keep the funds in the newly created Roth IRA for at least five years before withdrawing the money.
  • You may want to keep the money in the traditional IRA if you are in a high tax bracket now and expect to be in a lower tax bracket upon retirement.
  • If you plan to relocate to a lower income tax state or a state where there are no income taxes.

On the other hand, a Backdoor Roth conversion can be something to consider if:

  • You’ve already maxed out other retirement savings options.
  • You are a high-income earner.
  • You’re willing to leave the money in the Roth for at least five years (ideally longer).
  • You do not have other Roth assets.

Should I do a backdoor Roth IRA?

As you can see, the backdoor Roth strategy can be valuable in getting money into a tax-free account. And with the possibility that tax rates go higher from here, getting as much money into Roth IRAs now could pay off in the long run. But it isn’t right for everyone. So it’s important to ask yourself (or your financial advisor) whether a Roth IRA makes sense for you or not. And if you make too much to contribute to a Roth IRA directly, the answer might be no.

Think of it this way. If you are in a low tax bracket — say 10% or 12% — right now, it can make great financial sense to lock in your current tax rate by contributing to a Roth IRA, and to not have to worry about taxes in retirement. On the other hand, if you’re in a relatively high tax bracket right now and you qualify for the traditional IRA tax deduction, a traditional IRA might make more sense when it comes to tax optimization.

Of course, there’s more tax certainty with a Roth IRA, as there’s no way to know what U.S. tax brackets will look like by the time you’re ready to retire. Plus there are other benefits, such as no required minimum distributions (RMDs) and the ability to withdraw contributions whenever you want, that add value to the Roth IRA. 

Just because everyone can use the backdoor method of contributing to a Roth IRA doesn’t mean that everyone should. Before you start the process, make sure it’s truly the best move for your retirement strategy

Backdoor Roth IRA contribution limit

The IRA contribution limit for 2021–22 is $6,000 per person, or $7,000 if the account owner is 50 or older. So if you want to open an account and then use the backdoor IRA method to convert the account to a Roth IRA, that’s the maximum you can contribute for those tax years. 

It’s worth noting that you can make IRA contributions until the tax deadline, so if you make your contribution after New Year’s Day, you can effectively make two years’ worth of contributions at once. 

Benefits of a Backdoor Roth IRA

You May Reduce How Much You Ultimately Pay in Taxes

If you withdraw funds from a traditional IRA prior to age 59½, you’ll likely be hit with a 10% penalty—not so with Roth IRAs (as long as you’ve held the Roth for five years and you’re withdrawing contributions and not earnings).

Beyond that, if you anticipate your tax rate will be higher in retirement than it is today, contributing to a Roth IRA through the backdoor could reduce your lifetime tax liability.

You Can Avoid Required Minimum Distributions (RMDs)

With tax-deferred accounts like 401(k)s and traditional IRAs, you’re required to begin taking minimum distributions when you turn 72. Consider it the federal government’s way of nudging you to pay taxes on these funds. Roth IRAs, on the other hand, are not subject to RMDs—even if contributions are made through a backdoor Roth IRA conversion—because you’ve already paid taxes on the contributions. If you want to continue growing your money by keeping it invested, you’re free to do so.

Should You Set Up a Backdoor Roth IRA?

If you’ve already maximized your contributions in your employer’s retirement plan and you want to save more but are above the current income limits, a backdoor Roth IRA is another way to keep saving for retirement.

Can I do a backdoor Roth IRA every year?

Yes, you can convert funds to a Roth IRA every year if you wish. However, you still need to stick to contribution limits, and you'll still have to pay income tax on your conversions. Also, remember that you can't reverse a backdoor Roth conversion—it's permanent.

Be careful setting up a backdoor Roth IRA

You can get started with the backdoor conversion by contacting your bank or brokerage, but you want to be careful. If you don’t follow these rules closely, you could get hit with a major tax bill.

Megan Gorman, a founding partner of Chequers Financial Management, says consumers should contact a tax professional first before attempting a backdoor Roth on their own.

“It’s a great idea, but the aggregation rules and the rules regarding nondeductible versus deductible are complex, so it’s hard for investors who are do-it-yourself-investors to get it right,” Gorman says. “They are fraught with risk — if you do it wrong, you can hurt yourself tax-wise. Tax professionals are the ones who can really give this advice because they see the whole picture.”

For example, you might be hit with taxes if your contribution to a traditional IRA generates earnings before you’re able to convert it into a Roth IRA. Those earnings are subject to tax.

So this is a great time to call in an expert financial advisor to help with your situation.

Tax Liability When Converting to a Roth IRA

Traditional IRAs are funded with pre-tax dollars. Depending on your income, these contributions may be deductible or non-deductible. So why is that important when you’re converting to a Roth?

The IRS doesn't allow you to dodge your tax liability. Typically, you'd pay taxes on these funds at your ordinary income tax rate when you withdraw them in retirement. If you're converting a traditional IRA that's composed of deductible contributions, you'd have to pay the tax due on those contributions and their earnings at the time of the conversion.

But what if you're converting nondeductible contributions? That's when things can get a little tricky. If your traditional IRA includes only nondeductible contributions, you'd pay taxes only on any amount above your tax basis. If you have traditional IRAs that include both deductible and nondeductible contributions, however, the IRS will calculate any taxes due on the conversion on a pro-rata basis, using the value of all your IRAs.

That means if you have $300,000 in traditional assets and contribute the maximum $6,000 to a nondeductible IRA, you couldn’t just transfer the nondeductible portion, even if it’s in a separate account. You’d have to treat that $6,000 as partial conversion of your total IRA assets for tax purposes.

If you are age 50 are older, the maximum annual contribution to a Roth IRA is $7,000 for both 2022 and 2021.

Use a reverse rollover to avoid the pro rata rule

If your employer’s 401(k) plan allows you to roll IRA money into it, you can move your deductible IRA contributions and pre-tax earnings into the 401(k). This is a good move if your employer’s plan offers solid, low-cost investment options.

Then you can convert any remaining non-deductible contributions you‘ve made to a traditional IRA into a Roth IRA. In this case, you’d owe no taxes on the conversion and would be able to take advantage of the Roth IRA’s benefits.

Andrew Westlin, CFP, a financial planner at Betterment, says this can be a great strategy — but it’s only effective if the plan’s sponsor allows rollovers and if the individual has been keeping tabs on their tax basis for any accounts.

“You, as the investor, need to know how much non-deductible basis you have in your IRAs so we can accurately determine how much can be converted and how much needs to be rolled in,” Westlin says.

General rules and tax considerations

Because Roth IRA withdrawals are tax-free, contributions are made after taxes. If you are converting pretax monies from a traditional IRA to a Roth account, taxes will still be due at the end of the year.

Backdoor Roth IRA Pitfall #3: Unintended Costs

If you’re in your 60s or older, it’s vital to understand that other parts of your financial life, namely your Social Security and Medicare benefits, could be impacted if you technically realize income through a Roth IRA conversion.

  • Taxation of Social Security benefits. If you’re already receiving Social Security benefits, they may be partially taxed based on your income. If the backdoor Roth IRA bumps your income higher, you may find your Social Security benefits are partially taxable or a greater portion of your benefit could become taxable.
  • Higher Medicare Part B premiums. Nearly all Medicare enrollees pay a monthly premium for Medicare Part B, which covers doctor visits, tests and outpatient treatment. The monthly premium is based on your MAGI reported on your tax return from two years ago. There are also income-based premiums for Medicare Part D that cover prescription drugs.

The Bottom Line

A Roth IRA conversion can be a very powerful tool for your retirement. If your taxes rise because of increases in marginal tax rates—or because you earn more, putting you in a higher tax bracket—then a Roth IRA conversion can save you considerable money in taxes over the long term. The backdoor strategy opens the Roth door to high-earners who normally would be ineligible for this sort of IRA, or who are unable to move money into a tax-free account by any other means.

However, there are several drawbacks to a conversion that should be taken into consideration—particularly a big tax bill that can be tricky to calculate, especially if you have other retirement accounts funded with pretax dollars. It’s important to think carefully about whether or not it makes sense to do a conversion and consult with a tax advisor about your specific situation.

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