Indirect Roth IRA Contributions: Backdoor or Trapdoor?

The backdoor Roth IRA contribution is a great way for some higher-income workers to establish a Roth IRA without incurring income tax. But while it works perfectly for some, it is useless, or worse, a trapdoor for others.

Your three new clients, Don, Ron, and Lon, would each like to create a Roth IRA but:

• They do not want to have to pay income tax to do so. So, they do not want to convert money from any existing retirement plan to a Roth IRA.
• Each had "compensation income" in 2020 sufficient to allow the maximum IRA or Roth IRA contribution ($6,000, or $7,000 if age 50 or older by year-end) and is eligible to contribute the maximum to an IRA for 2020.
• Each client's adjusted gross income, or AGI, for 2020 exceeded the level above which he is not permitted to make a "regular" contribution to a Roth IRA for the year, that is $196,000 (if married filing jointly) or $124,000 (if single). These AGI limits effectively bar our higher-income clients from making direct Roth IRA contributions.
• Finally, each client participated in his employer's 401(k) retirement plan for 2020 and had 2020 AGI exceeding the level at which an employer-plan participant can make a tax-deductible contribution to a traditional IRA. Any client who exceeds the Roth-IRA-direct-contribution income limits automatically also exceeds this limit, which kicks in at much lower AGI levels.

The apparent prescription for this situation is the backdoor Roth contribution: The client contributes up to the applicable maximum to a traditional IRA, then converts that IRA to a Roth. Since the traditional IRA contribution was nondeductible, the entire conversion amount (except for investment growth, if any, between the contribution date and the conversion date) is aftertax money; as a result, the conversion is all or mostly nontaxable and the client now has his/her desired Roth IRA without increasing current income tax.

Note: Although there is no legally required waiting period before an IRA contribution can be converted to a Roth, it is important to be sure the traditional IRA is properly established and shows it received the contribution before converting. Some advise holding off the conversion until you receive the month-end account statement showing the contribution was received and is held in the account--a nice clear paper trail.

This two-step maneuver is legal due to a quirk in the IRA rules: There is an income limit on direct Roth IRA contributions, but there is (since 2010) no income limit on Roth IRA conversions. Someone who is income-barred from contributing directly to a Roth IRA can convert unlimited amounts from a traditional retirement plan to a Roth IRA. Any doubts about the legality of the backdoor Roth contribution went away once the Joint Committee on Taxation, in its report on the Tax Cuts and Jobs Act of 2017, favorably mentioned this approach four times in its "Joint Explanatory Statement of the Committee of Conference" (see footnotes 268, 269, 276, and 277). In 2020, the maneuver became legal even for individuals over age 70 1/2 (prior to that year they were barred from making traditional IRA contributions).

But this nifty invention becomes a trapdoor if the client has other traditional IRAs or acquires other traditional IRAs (for example, by rolling over money from an employer plan into an IRA) before the end of the year of the conversion.

The trapdoor gets sprung because of the way Roth conversions are taxed: A Roth conversion is taxed the same as a distribution from the IRA would be taxed, that is, it is generally includible in gross income except to the extent it represents a distribution (or conversion) of aftertax money--the IRA owner's basis. To determine that nontaxable portion, you multiply the total conversion amount by a fraction: The numerator of the fraction is the individual's basis in all of his traditional IRAs collectively and the denominator is the combined balance of all of his traditional IRAs. This balance is based on the year-end value of all of the individual's traditional IRAs plus amounts distributed from any traditional IRA during the year.

In other words, you do not look only at the actual IRA converted. You must count all the individual's traditional IRAs--including IRAs created or augmented later in the conversion year by rollover or otherwise. These unwelcome facts will separate successful from unsuccessful backdoor Roth contributions.

Suppose Don, Ron, and Lon are all over 59 1/2. Each contributes $7,000 to a newly created traditional IRA in February 2021. These are 2020 contributions, the deadline for which is April 15, 2021. The new IRA is converted to a Roth IRA a month later, by which time it has grown to $7,005. Although the contributions are considered "2020 contributions," the conversions are taxed as 2021 conversions (unlike IRA contributions, conversions are never "backdated"). Assume each client has no other aftertax money in any retirement account.

So, for each, the income-excludible portion of this conversion will be: $7,000 (the aftertax contribution to the new traditional IRA) divided by the combined total of all his countable IRA balances, times $7,005 (the amount of the Roth conversion). Now watch:

Don: At the time of the Roth conversion, Don has no other traditional IRAs; the $7,005 IRA he converts to a Roth is his only IRA. Nor has he had any other IRAs previously in 2021 (other traditional IRAs that existed earlier in 2021 but were converted to Roths or distributed prior to this conversion). Assuming Don makes no other IRA contributions (regular or rollover) in calendar 2021, the portion of his Roth conversion that is excludable from income is $7,000/$7,005 x $7,005 = $7,000, so the taxable portion is only $5.00. For Don, the backdoor Roth contribution works as intended: He gets a new $7,005 Roth IRA but has to pay tax on only $5 of income. Don is the ideal backdoor Roth contribution client. (Don could even do another backdoor Roth contribution in 2021, for the 2021 year--once he knows for sure that he will have sufficient 2021 compensation income to support a 2021 IRA contribution, plus ongoing participation in his employer's 401(k), and high enough 2021 AGI to rule out both a direct Roth contribution and a tax-deductible 2021 contribution to a traditional IRA.)

Ron: In contrast, Ron's conversion is a waste of effort. Ron owns other traditional IRAs worth $2 million, all pretax money. The fraction applied to his conversion will produce a minuscule tax-free portion: $7,000/$2,007,005 x $7,005 = $24.43 of tax-free return of basis! For someone who owns significant other traditional IRAs, the backdoor Roth contribution simply does not work. If that client wants a Roth IRA he might as well convert some of his existing IRA money. Adding a $7,000 aftertax contribution to a new or existing IRA will produce virtually no benefit for this client.

Lon: Finally, Lon illustrates the trapdoor. At the time of the conversion, Lon has no other traditional IRAs in existence, nor has he had any other such IRAs previously in 2021. He thinks all is well. But then, later in 2021, Lon retires and rolls over the balance from his former employer's 401(k) plan (100% pretax money) to an IRA. The year-end value of rollover traditional IRA goes into the denominator of the fraction. Effect: He has now irretrievably contaminated the conversion he did earlier in the year. Assuming the rollover IRA is worth $500,000 as of Dec. 31, 2021, his conversion fraction becomes $7,000/($7,005 + $500,000 = $507,005) x $7,005 = $96.72. The tax-free portion of his $7,005 Roth conversion is only $96.72; the rest ($6,908.28) is includible in his gross income. This is a mistake that cannot be fixed, since Roth conversions cannot be reversed.

Moral of the story? Use the backdoor Roth contribution as a legal and viable tool for your clients who fit the profile and have no other traditional IRAs. To avoid the trapdoor, make sure the client does not roll any other money into any traditional IRA for the rest of that calendar year.

Where to read more: For more on how Roth conversions are taxed, see Instructions to IRS Form 8606, and ¶ 2.2.08, ¶ 2.2.10, and ¶ 5.5.03 of the author's book Life and Death Planning for Retirement Benefits (8th ed. 2019; www.ataxplan.com).

An earlier version of this article reversed the terminology in the Don examples. It has been corrected to list taxable and income-excludible where appropriate.

Natalie Choate is an estate planning lawyer in Boston with Nutter McClennen & Fish LLP. Her practice is limited to consulting regarding retirement benefits. The 2019 edition of Choate's best-selling book, Life and Death Planning for Retirement Benefits, is available through her website, www.ataxplan.com, where you can also see her speaking schedule and submit questions for this column. The views expressed in this article may or may not reflect the views of Morningstar.