Backdoor IRA Pitfalls to Avoid

Christine Benz: Hi, I’m Christine Benz from Morningstar. The backdoor Roth IRA was reported to be on the chopping block, but it’s lived to see another day. Joining me to discuss what you need to know if you’re considering a backdoor Roth contribution is Ed Slott. He is a tax and retirement planning expert.

Ed, thank you so much for being here.

Ed Slott: Thanks, Christine.

Benz: Let's talk about this backdoor Roth provision. We thought that it might be on the chopping block. Turns out it lived to see another day in 2022. What should people know if they want to take advantage of this backdoor Roth? Maybe first talk about what it is.

Slott: Well, some people want to do a Roth contribution, and that's not all we're talking about, not conversions where you can convert unlimited funds. So, all we're talking about is making a Roth contribution, which the maximum for '22 is $6,000, or $7,000 if you're 50 or over. So, that's what we're talking about. But some people whose income is too high, and it's a high level, they can't do it, they don't qualify. There's an income limitation. So, over years, people called it a backdoor Roth. And the IRS is OK with it. Even Congress was OK with it. But in the Build Back Better Bill--that's some alliteration there--Build Back Better Bill that was one of the first items on the chopping block. Apparently, Congress is not OK with that, and they said that would be the first thing to go. It was supposed to be banned beginning in 2022 regardless of income level, so across the board. But as we speak, depending on when you're watching this program, the Build Back Better Bill is in pieces. So, we don't know what's going to happen, but we know Congress has their eye on it.

What do you do for 2022? Well, technically, it's still allowable. So, I guess, you could do it, or if you want to be more conservative, you may want to hold off until you know for sure. But if you do it, if you do the backdoor Roth and what you do since you can't contribute to a Roth directly, you contribute to a traditional, which has no income limits, a traditional nondeductible IRA, and then soon after you can convert it to a Roth, so you'll end up in the same place. That's why they call it the backdoor Roth. But once you do a conversion, you can't go back. Now, the Build Back Better Bill had a provision to ban this as of Jan. 1, 2022. I think even if this thing resurfaces, they would have to change the effective date. So, I think you're probably OK if you do it now, because even if somehow this got through as law, there is no mechanism to undo it, because remember the last step is a Roth conversion, and under the tax law, Roth conversions cannot be undone. How could they make you undo something that the tax law says you can't undo? It'd be a real mess. If anything, if it ever came to be that Congress got their wish and banned these things, they'd have to do it prospectively, just my opinion. Because it would be a mess otherwise. So, technically, I believe it is available now.

Benz: Good to know. You think it's unlikely that it would be retroactive. I want to talk about some of the things that can kind of trip up people as they go about executing this backdoor Roth or a two-step Roth IRA maneuver. One of the things is this piece of paperwork that should accompany that contribution, this form 8606. What do people need to know about that?

Slott: Well, 8606 comes into play whenever you make a nondeductible contribution to your IRA. You're supposed to keep track because you didn't get a tax deduction. So, you have a benefit called basis. In other words, when the money comes out, you shouldn't pay tax on that money, but it's a little more complicated than that. You can't just pull out the aftertax money and pay no taxes, what's called a pro rata rule, and that calculates itself on your Form 8606. But that's up to you. Nobody reports that. You have to report that on your own tax return. So, when you convert on this backdoor Roth, let's say, you did $6,000 or $7,000 and then you convert it, you didn't get a deduction. You have to take all your other IRAs into account. Many people think, well, I didn't get a deduction. I did a $6,000 contribution to a nondeductible IRA. So, I can convert the whole $6,000 right to a Roth tax-free. No, not if you have other IRAs. They have to be taken into the mix. So, it's not that complicated, but it's a formula basically that the percentage of your aftertax money compared to the value of all your IRAs, that's the part that's going to be tax-free. In many cases, if you have a large IRA balance, $6,000 over $200,000, $300,000, $400,000 isn't going to be much that's tax-free. So, generally, most people with other IRAs will end up paying tax, but they still get the money in the Roth.

Benz: Well, that's what I wanted to ask for someone who has, say, a lot of rollover assets that have never been taxed, is the presence of those assets in this pro rata rule that you just discussed, should that be a disincentive to go ahead and take advantage of this backdoor Roth maneuver?

Slott: No, I don't think so. Remember, you're not talking about big amounts, $6,000, $7,000 at most, and you still end up getting the funds in the Roth that begin to grow tax-free. And if you're a married couple, you may be able to double that, husband and wife.

Benz: Right. Another question that kind of comes into play with these backdoor Roth contributions is how long you need to wait from the time that you put the money into the traditional IRA and when you convert it. Is there any sort of rule of thumb that people should bear in mind?

Slott: I have my own rule: There's no rule of thumb. And Congress was OK with that. They are OK with the backdoor Roth, so is the IRS. In fact, we used to think--a lot of tax people when this first came out--"Oh, that's a step transaction." None of that. You don't have to worry about that. As a matter of fact, in the original House bill, not the bill, but their explanation that they put out, they even used the word you make a contribution to a traditional IRA, and then shortly thereafter convert it. So, they know that's what happens. My own rule is, I say, wait one month. So, you get monthly statements generally on your IRA. This way at one moment in time you see it in the IRA, and the next moment in time you see it in the Roth. So, there's some separation. That's just a practical aspect. But there's no real waiting period. Many people were worried about that early on. I think now they're just more worried about is if the benefit is going to continue.

Benz: True. Can you discuss if someone waits too long, the potential issue with that related to the conversion taxes. Can you talk about that?

Slott: Yeah, it could be. If you did the contribution to the traditional IRA--when this first came out, there was another speaker out there saying, "Oh, wait a year." I wouldn't wait. I would wait till it resolves itself, maybe in one statement period and then convert it. I wouldn't wait too long. Exactly as you said, that could be messy. If you have it in the traditional IRA, then all of a sudden, some bill comes out, some piece of this Build Back Better Bill and says, that's out, then you might be stuck.

Benz: Ed, great overview of what's going on with the backdoor Roth. Thank you so much for being here.

Slott: Thanks, Christine.

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