A Backdoor Roth is a strategic conversion of your traditional IRA into a Roth IRA. It allows you to circumvent the Roth income restrictions and contribute to the retirement vehicle even if you’re earning more than $135,000 a year.
The Backdoor Roth was made available to all investors regardless of income in 2010. That was when Congress allowed investors to get around the Roth IRA income limit via a traditional IRA. It has only been around 10 years, which is why you may not have heard of it.
It’s important to note, however, that the Internal Revenue Service (IRS) hasn’t formally acknowledged the existence of the Backdoor Roth. Like so many things tax related, your ability to contribute via a Backdoor Roth might change if the IRS decides that the loophole is in violation of their policies.
Lookin’ Out My Back Door
My parents were born in the 1950’s, the last of the boomer generation. My dad came of age in the early 70s and so he played a lot of Credence Clearwater Revival. One of my favorite songs was Lookin’ Out My Back Door. It has crazy imagery that appealed to me as a young kid (Tambourines and elephants are playin’ in the band) and it’s also somehow a song about Illinois, where I grew up.
Every time I hear the financial planning term “Backdoor Roth”, I sing the refrain from the song … Doo, doo, doo, lookin' out my back door. Maybe it’s because the entire concept seems crazy: Fundamentally, it is a way for people with high incomes to dance around the IRS income limits for Roth IRAs.
I’ve developed a bit of a habit for linking Roth concepts to musical groups. Last time it was Van Halen. Let’s shift the analogy this time from the best big-hair band of the 80s to the baddest classic rock band of the 70s.
First, you must determine: Are you a fortunate son (or daughter)? A Backdoor Roth is a great strategy, but it is not right for everyone. Here’s a handy guide to determine if it is music to your ears:
Does this sound like your kind of jam? Keep reading to find out more.
Run Through the Jungle
Here’s a very simplified, two step guide on how to make a Backdoor Roth IRA conversion:
Step1: Open up a non-deductible traditional IRA account and contribute up to $6,000 (or $7,000 if you’re older than 50).
Step 2: As soon as the funds are in your traditional IRA and before they accumulate earnings, transfer or “roll over” your money into your Roth IRA. Since they haven’t accumulated any interest, this is considered non-taxable.
You’re now able to contribute to a Roth IRA no matter what your income is. A Backdoor Roth mostly boils down to this: Some fancy administrative paperwork. If you’d rather have me worry about it, I’m happy to do so.
So why would you hire someone to do this when the steps seem so easy? Because the Backdoor Roth is not without risks, complications and a few confusing rules.
The ability to contribute is a powerful loophole. This isn’t a way to dodge your taxes, however. You still need to understand all of the tax implications before you decide to leverage a Backdoor Roth to make sure that it’s right for you.
Bad Moon Rising
Leveraging a Backdoor Roth does NOT mean you won’t be taxed. If you convert your traditional IRA into a Roth IRA you will be taxed on any deductible IRAs you have when you file your taxes at the end of the year.
This is the Pro-Rata rule, a method of determining what money is taxable if you hold both pre- and after-tax money across ALL of your IRAs. When determining your tax bill on a conversion from a traditional IRA to a Roth IRA, the IRS is going to look at all of your traditional IRA accounts combined.
If all of your traditional IRAs combined consist of, say, 70% pre-tax money and 30% after-tax money, that ratio determines what percentage of the money you convert to a Roth is going to be taxable.
In this example, no matter how much money you convert or which IRA account you pull the money from, 70% of the amount you convert to the Roth will be taxable. You can’t choose to convert only after-tax money; the IRS won’t allow it. And a word about timing: The IRS applies the pro-rata rule to your total IRA balance at year-end, not at the time of conversion.
I know it’s confusing, and not a simple melody to sing on your own. But if a Backdoor Roth suits your financial situation, then it can be a useful loophole to avail of.
As I wrote in my previous blog post, retirement is a time to enjoy the fruits of your labor, not stress about the perils of financial mistakes. If you’re interested in converting your traditional IRA to a Roth IRA but feel unsure about how to step through the backdoor, don’t be too proud to call me to look at your specific situation and see if it makes sense for you.