There are lots of articles out there touting the benefits of ‘backdoor’ Roth conversions. Many of these articles will even ‘show’ you how to do them.
As straightforward as they might appear in a Forbes article, there are many things that might trip you up if you’ve never done a backdoor Roth conversion before.
This article is a case study based on a real client scenario. I’ve changed some information to protect confidentiality, but the principles are the same.
This article will explain:
- The difference between a traditional IRA (individual retirement account) and a Roth IRA
- How nondeductible IRA contributions work
- What a backdoor Roth IRA conversion is
- One key thing you should know about nondeductible and deductible IRAs
- A client story about a backdoor Roth conversion and some of the lessons we learned
- Considerations for your own backdoor Roth conversions
As a caveat, this is not tax advice, investment advice, or legal advice. When creating your Roth IRA conversion strategy, it’s best to do so with the advice of your financial planner or tax adviser.
The difference between a traditional IRA and Roth IRA
Before we go in depth, we should understand what a backdoor Roth conversion is. But to understand this, we need to understand a couple of things about IRAs.
Let’s take a step back to discuss the difference between three types of IRAs.
According to the Internal Revenue Service (IRS), a traditional IRA is any IRA that isn’t a Roth IRA or a SIMPLE IRA (employer-sponsored). In layman’s terms, this is an account that you open, contribute earned income to, and invest on a tax-deferred basis.
You may (or may not) be able to take a tax deduction on your IRA contribution from when you file your annual tax return. The deductibility of your IRA contribution depends on:
- Your adjusted gross income level, and
- Whether you (or your spouse) contribute to an employer-sponsored retirement plan at work.
However you invest your traditional IRA contributions, your earnings are tax-deferred. In other words, you don’t get taxed on earnings while they’re in the IRA.
When you eventually withdraw your money, the distributions are considered to be taxable as ordinary income. Unless you meet certain eligibility criteria, you may also be subject to a 10% penalty on distributions made before age 59 ½.
A Roth IRA is pretty much the opposite of a traditional IRA. Instead of deducting your contributions, you make your Roth IRA contribution with after-tax money. This is money that you’ve already paid income taxes on.
In exchange, you are able to receive make tax-free withdrawals on qualified distributions.
Technically, a nondeductible IRA is a traditional IRA, in which you were not able to deduct contributions on your tax return. Otherwise, treated like a traditional IRA—tax deferred earnings, taxable distributions.
But withdrawals are taxed and subject to early withdrawal penalties.
- Traditional IRA = pre-tax money goes in, pay federal income tax on the way out
- Roth IRA = after-tax money goes in, don’t pay taxes on the way out
However, there are some other differences worth noting. Although most of those differences are outside the scope of this article, the IRS has a nice side-by-side chart comparing Roth and traditional IRAs.
How does a non-deductible IRA contribution work?
A non-deductible IRA contribution works in a similar manner to a deductible IRA contribution. The only difference is that you don’t deduct the contribution on your tax return. Let’s look at how this is different from a deductible IRA contribution.
Deductible IRA contribution
Make the contribution. This can be up to 100% of your earned income, or $6,000 in 2022 ($7,000 if the IRA owner is age 50 or older).
Take the deduction on the tax return. This will be in Block 20, Section II of Schedule 1. This deduction is known as an ‘above the line’ deduction. This means that it will directly lower your adjusted gross income (AGI).
Non-deductible IRA contribution
Contribute to a nondeductible IRA.
Report the contribution. Instead of deducting the contribution on Schedule 1, you will report the contribution by filling out Form 8606, Nondeductible IRAs.
What is a Roth conversion?
So, to understand what a backdoor Roth conversion is, we must first understand what a Roth conversion is. Simply put, a Roth conversion is where you:
- Take money from a traditional IRA
- Transfer the money into a Roth IRA account
- Pay taxes on the converted amount
Why would you do this? Primarily because you are in a lower tax bracket (or you believe that you are) than you might be later on in life.
This is particularly true for people who have recently retired. Their taxable income is lower than in their working years, but they have not started collecting Social Security yet. They’re also subject to required minimum distributions (RMDs) from their retirement accounts.
The theory is that if you pay your taxes at a lower tax rate, then you’ll pay less in taxes over the course of your life. To go further would require more in depth discussion, which is beyond the scope of this article.
What is a backdoor Roth conversion?
A backdoor Roth conversion is a conversion of money from a nondeductible IRA to a Roth IRA.
This mostly appeals to people who cannot make a direct Roth contribution in the first place. Usually, it’s because there are Roth IRA income limits. In other words, if you earn too much money, you can’t contribute directly to a Roth account.
But you can still contribute to a nondeductible IRA. And since you already paid taxes on those nondeductible contributions, the effect is the same as if you contributed directly to the Roth IRA account.
The steps are fairly straightforward:
- Contribute to a nondeductible IRA.
- Do a Roth conversion from your nondeductible IRA. Your financial institution can usually help you with the paperwork.
- Track your contribution and conversion on Form 8606-Nondeductible IRAs when you file your tax return.
That’s really it. But, the devil is in the details.
Key things you should know about your IRAs
There are three things you should know about your IRAs. First, you should know what a backdoor Roth conversion is. Second, you should be aware of the IRS rules in place that govern IRA taxation. Third, you should know the limitations of these IRS rules.
Let’s start with what a backdoor Roth conversion actually is.
Backdoor Roth conversion
Just the term, ‘backdoor’ implies that there’s something sneaky. After all, you’re doing something that amounts to a Roth contribution, but requires additional steps. That seems like something the IRS rules would try to prevent.
Indeed, that is what used to happen. However, one result of the Tax Cuts and Jobs Act (TCJA) was that Congress recognized and legitimized backdoor Roth conversions in the TCJA Conference Report (footnotes 268 and 269). Then, Congress debated taking this away when President Biden presented his Build Back Better plan in 2021.
So, whatever the IRS used to say about backdoor Roth conversions, they’re here to stay, thanks to Congress. For now.
However, there are a couple of IRS rules you have to be aware of. One of them is the IRA aggregation rule.
IRA aggregation rule & pro-rata rule
According to the Internal Revenue Code (IRC Section 408 (d)(2)), all IRAs are aggregated for tax purposes.
Let’s imagine that you have a nondeductible IRA, and you have a separate deductible IRA. If you start doing Roth conversions, you might assume that you can just do Roth conversions from the nondeductible IRA. That would allow you to avoid paying taxes on today’s Roth conversions.
But you can’t do this. Since IRAs are considered to be one big IRA for tax purposes, that leads us to the pro rata rule.
Since all IRAs are counted as one, you have to consider each withdrawal on a pro-rata basis. And you have to pay taxes accordingly. Roth conversions are considered withdrawals for this purpose.
Simply put, if you have an IRA (or multiple IRAs) with deductible (pre-tax) and non-deductible (after-tax) contributions, then you have to aggregate & pay taxes on a pro-rata basis for any Roth conversions from both pre-tax and after-tax dollars.
For example, let’s imagine that you deposit $5,000 into a nondeductible IRA. And you already have $45,000 in a traditional IRA (all pre-tax). Now you want to make a $5,000 Roth conversion.
Simply make a $5,000 Roth conversion from the nondeductible IRA while leaving the traditional balance alone.
Consider that you have a $50,000 total IRA balance. Your Roth conversion amount of $5,000 represents 10% of the total IRA assets. Therefore, your tax treatment is as follows:
- 10% withdrawal from the $45,000 IRA: $4,500 (fully taxable)
- 10% withdrawal from the $5,000 IRA: $500 (not taxable)
Even if they are in two separate IRA accounts, the IRA aggregation rule forces you to consider all contributions as if they’re in one account.
The IRA aggregation rule only applies to IRAs
It does not apply to contributions to an employer-sponsored retirement plan. This is a key distinction. And this is where a key tax planning opportunity lies.
There are a few more complexities to Roth conversions, but these are the ones that pertain to this client story.
Client Roth conversion case study
One of my previous doctor clients is a really good saver. She had been maxing out her workplace retirement plan. And she had been making non-deductible IRA contributions for several years. During a meeting, she asked about doing a backdoor Roth conversion with her non-deductible contributions.
Unfortunately, the IRA where those contributions had been going (for several years) was also a rollover IRA from an old qualified retirement plan. There were about $105,000 in pre-tax contributions in the account. At the same time, there was only about $38,000 in non-deductible contributions.
This meant that to be able to get the full $38,000 converted tax-free, she would have to pay taxes on the other $105,000. As a single filer and a high-income earner, this did not make sense.
The additional challenge was that the non-deductible and deductible contributions were in the same account. This meant that we would have to identify the non-deductible contributions. Then, we’d have to somehow separate them from the deductible ones before we could even begin a Roth conversion.
Finally, this would only work on a tax-free basis if she participated in an employer-sponsored retirement plan that allowed transfers into the plan. Not all employers do this. Fortunately, she was a participant of the government’s Thrift Savings Plan (TSP), which allows transfers into their plan.
Why is this important? Because of this:
The only way to circumvent the IRA aggregation & pro-rata rules is to ensure that 100% of your IRA contributions are non-deductible ones.
To do this, we had to:
- Roll the pre-tax funds out of her IRA, and into the employer-sponsored plan,
- Convert the remaining (tax-free) contributions
- Account for everything on her tax return.
The pro-rata rules do not apply to an IRA rollover into a pre-tax employer-sponsored plan (like a 401k). That means you can roll pretax money into the workplace plan, isolate the nondeductible IRA contributions, and roll them over tax free. If done properly.
To avoid keeping you in suspense, we did this successfully. But it took a lot of work and coordination with her accountant. Fortunately, since we (our firm and the accountant) kept good records, we were able to go back into our client files.
From there, we determined how much of our client’s contributions had been non-deductible IRA contributions, and how much were originally rollovers from previous employer plans.
We identified the $38,000 in original non-deductible contributions, then transferred the rest into her TSP account. The $38,000 then became our client’s Roth conversion.
1. The importance of keeping good records.
Most of the time, your financial planner or custodian will have records that go pretty far back. However, when you have 20 or 30 years of investment history (which many people in their fifties do), odds are that you might not be with the same advisor.
Or the custodian you used to work with got bought by a bigger outfit that doesn’t have those records anymore. The only person you can rely upon to keep good records over long periods of time is you.
2. Keeping separate accounts for a non-deductible and deductible IRA.
Anyone who already has an IRA should establish a separate IRA for non-deductible IRA contributions. Even if you don’t make a Roth conversion in the current tax year, this will make it so much easier to identify how much of your IRA was from your non-deductible contributions (which you shouldn’t pay taxes on when you convert).
If you can’t do this, then you should become very familiar with IRS Form 8606-Nondeductible IRAs. This will allow you to go back and figure out which IRA contributions were deductible in previous tax years.
3. Don’t shut the door on your employer plan once you leave your job.
At least, take a look at your plan document to see if that plan accepts after-tax contributions. That’s the key to being able to isolate non-deductible contributions from your pre-tax ones.
The Thrift Savings Plan is ideal because it accepts after-tax contributions, has plenty of diversification, AND has some of the lowest costs of any plan out there! This conversion scenario was only available to our client because she kept her TSP account after she left her government job.
4. Sometimes, you can’t do this on your own.
Our client probably could have done this on her own. However, being a doctor, this probably would not have been a priority. And if she ever had the time to actually take the steps to do this, she would have had to take even more time just to learn the steps involved.
Fortunately for her, she hired an accountant and a financial advisor to take care of this for her.
5. It takes a team.
We would share client information with the accountant (and vice versa), with the client’s permission. Before we do anything that might create a significant taxable event, we coordinate with her accountant and get their blessing.
Then, at year’s end, we give the accountant a lot of information so it’s easier for them to prepare the client’s tax return.
There is plenty of online advice that tells you the simple steps involved in a Roth conversion. And for many people, it can be that simple. But not for everyone.
The tough part is finding out that you missed something that you really should have paid attention to.
This case study is just one of MANY ways that a Roth conversion can go awry, if you don’t pay attention to the details. And if you don’t have the experience, education, or the time to learn, you might consider hiring a tax-focused financial advisor to help you with your Roth conversion options.