What You Need to Know Before Funding a Backdoor Roth

Christine Benz: Hi, I'm Christine Benz for Morningstar.com.

Even if you earn too much to contribute to a Roth IRA outright, you can still get in through the backdoor. Joining me on the phone to share some tips on this strategy, is retirement expert and author Ed Slott.

Ed, thank you so much for joining me.

Ed Slott: Great to be here. Thanks.

Benz: So assuming someone is convinced that this Roth option is the better bet for them, but they can't make a direct contribution because they earn too much, one strategy that you and others have been talking about is going ahead and funding a traditional nondeductible IRA and then converting it shortly thereafter.

Let's talk about that so-called "backdoor Roth IRA" strategy. Are there any pitfalls that you should bear in mind if you're thinking that this might be the strategy that you want to undertake?

Slott: The one big pitfall about contributing for retirement is you have to realize, whatever age you are, mostly for younger people under 59 1/2 I should say, that that money is for retirement. The problems come, the pitfalls, whatever you call them, usually come in if you want to tap into that money before 59 1/2; that's a problem. So that's the first thing. You have to look at this as a long-term project--retirement.

So this backdoor Roth conversion, yes, if you make too much money, you can't contribute to a Roth. But it's unusual because conversions, which is the other type of Roth--that's not where you contribute, but where you convert an existing 401(k) or an IRA to a Roth--there is no income limit on that. I mean, if you had $1 billion in an IRA, you can convert it to a Roth, no income limits. So it's funny, for a $5,000 or $6,000 contribution, then [the IRS is] going to have income limits. They're not going to let people just put $5,000 into a Roth; $1 billion is fine, but not $5,000. So I think it's a flaw in the thinking of the law, maybe an unintended consequence or something.

So here's what you can do, though. You can contribute to an IRA, and as I said before, when I say IRA, traditional IRA, it may be deductible or not. You could always, if you have the earnings, and you're not yet 70 1/2, you can always contribute to an IRA, so that's a common misconception. People say, "Well if I make too much, I can't contribute to an IRA." No, if you make too much, you can't contribute to a Roth IRA, but there's no income limit on contributing to an IRA. So again, if you make millions of dollars, you can still contribute to an IRA. The question is, "Can I deduct that contribution?" and if you're active in a plan and you make too much money, then you can't deduct it. So you have a nondeductible IRA. But if you really wanted to do a Roth, but you couldn't do it because of the income limits, then contribute to a nondeductible traditional IRA, and then wait a few days or a week until it settles, and then convert it, because there is no income limit for conversion. So there's an easy way around it, and that's what people are doing that want to have the money ending up in a Roth IRA.

The only difference is, though, when you convert it, the dollars went into a Roth as a conversion, not as a Roth contribution, and there are slight differences.

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For a Roth contribution, remember I said before, the problems [can occur] if you need the money early. If you don't need the money early, it's no problem. But if you need to tap into your Roth, the contribution is better, the Roth contribution, because with a Roth contribution you can withdraw your original contributed Roth amounts anytime for any reason, tax and penalty free. Now that's not true with a conversion.

So with the backdoor Roth conversion, where you contribute to a nondeductible traditional IRA, wait a week and then convert it to a Roth, the way the money got into the Roth is as a conversion, not a contribution. With a conversion, if you're under 59 1/2, you have to wait five years before you can touch that converted money, because if you touch it before you're 59 1/2 and you haven't held it for five years, you'll have a 10% penalty. So again, it comes back to this money has to be long term or at least over five years.

Benz: So, you need to be careful there. One other thing I'd like you to touch on, Ed, is this issue of people who have other IRA assets, other traditional IRA assets, and they think they will go ahead and do one of these backdoor IRAs. Let's talk about some of the unintended tax consequences that can happen as a result of that maneuver?

Slott: Well, there is a so-called rule, you won't see it in the tax code, but you have to consider all your IRAs--so it's become known as the pro rata rule. Where, for example, if you make a $5,000 contribution--and the reason I said $5,000 or $6,000 before, the contribution limit for IRAs and Roth IRAs is $5,000 per year, but if you are age 50 or over, you could make another $1,000. So if you're 50 or over by the end of the year, you can [contribute] $6,000.

So ...  when I said contribute to a traditional IRA and then convert it to a Roth, let's say your amount was $5,000. So you can't just contribute $5,000 to a traditional IRA, then convert it to a Roth and pay no tax. You could if you had no other IRAs. But if you have other IRAs, you have to take those into account, and a lot of that money might have earnings, might be pre-tax money.

So let me give you an example; let's say you had no other IRAs, and you just contributed $5,000 to a nondeductible IRA, waited a couple of days or a week, and then converted it to a Roth. You won't pay tax on any of that money. So the net result is as if you just contributed $5,000 to a Roth. That's why they call it a backdoor Roth conversion.

But let's say, instead, you wanted to do the same thing, but you had $95,000 of other IRA money, even if it's in all different accounts spread all over the place. Under the tax law, all IRAs are considered one IRA. So let's say the total balance in your IRAs was $95,000, and now you contributed another $5,000 to a nondeductible and converted it. There is a pro rata rule where you have to consider all that other money that hasn't been taxed yet. So it's really just a fraction, and the fraction is the amount, the $5,000 [of post-tax money] that you're converting, over the balance of your entire IRAs, which is $100,000 now, the $5,000 plus the $95,000. I know it sounds like it's getting technical, but the point is, only 5% of your $100,000 now, the $5,000 over the $100,000, is tax-free, which means 95% is taxable. So if you convert that $5,000, 95% of it will be taxable as opposed to my other example, where you didn't have any other IRAs, and it was all tax-free. So that's a trap you have to watch for.

Benz: So, maybe not such a great strategy for people who have a lot of traditional IRA assets sitting on the sidelines?

Slott: Well, maybe not. But remember, that money is going to get taxed anyway. So, if you look at it that way, at some point that money is going to come out. So you will get some credit--like in my extreme case, you'll only get 5% of the tax-free amount out, and if you happen to convert everything, for instance, in my example, if you converted the whole $100,000, you'd only pay tax on the $95,000, and the $5,000 would come out and would be converted tax-free. So, it's just something you have to be aware of; it could cause you to pay more tax than you may have planned on. It wouldn't all be tax-free.

But the more money, in my opinion (and other people disagree; you're just getting one opinion here), I believe the more money you can stuff away in tax-free territory, the better hedge you have against future tax rates increasing on your retirement savings.

The other thing I like about the Roth is, not only can you buy off the tax now at what may be the lowest tax rates we'll ever see in our lifetime, that's where we are right now, but then all the growth [is also tax-free] ,So, if you do a traditional IRA, yes you get a tax deduction, but all the growth is subject to tax [when you withdraw]. But if you bite the bullet now, pay the tax and have it in a Roth IRA, all the future growth is for you and your family forever tax-free. That's a big deal.

Benz: Ed, thank you so much for sharing your wealth of insights on this very important topic. There are obviously lots of complexities, and it's great to have you here to help us navigate.

Slott: Thanks, Christine.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.