It has been five years since the income limits on IRA conversions were lifted, effectively putting Roth IRA investments within reach of higher-income individuals who had previously been shut out because they earned too much to make a direct contribution.
The maneuver is simple enough and should be tax-free in many cases. An investor who earns too much to make a direct Roth IRA contribution (the income limits are here) simply opens a Traditional nondeductible IRA--available to investors regardless of income level. Shortly thereafter--and here's where the backdoor part comes in--he converts it to a Roth IRA, another move now unrestricted by income limits. Assuming he has no other IRA assets, the only taxes due on the conversion would be any appreciation in the investments since he opened the account. That taxable amount should be limited, assuming he converts the money promptly and/or leaves the money in cash until the conversion is finalized.
That sounds straightforward--and, in most cases, it is. However, there are a few potential snags that would-be backdoor Roth IRA contributors should bear in mind before they execute this move. Some fall into the category of fairly minor mistakes, while others are costly errors.
Mistake 1: Not Paying Attention to the Pro-Rata Rule
If you've heard about any sort of hitch with a backdoor Roth IRA, you've probably heard about the pro-rata rule. What that means is that if an investor owns additional Traditional IRA assets that have never been taxed, such as a rollover IRA--in addition to the new Traditional IRA that she hopes to convert to a Roth via the backdoor--the taxes she'll owe on the conversion will depend on her ratio of IRA assets that have been taxed to those that have not. If the old, never-been-taxed IRA assets dwarf the new IRA consisting of already-been-taxed assets, most of the new IRA assets will be taxable when converted to Roth. This article describes the problem in detail.
Avoid By: Taking stock of the tax characteristics of all IRA assets you hold in your name before embarking on any sort of conversion.
Mistake 2: Not Taking Advantage of the Escape Hatch
As nettlesome as the pro-rata rule can be for would-be backdoor IRA contributors, investors who are contributing to a high-quality company retirement plan may have a workaround. Assuming their company plan allows for "roll-ins"--additions of IRA or 401(k) assets from outside the plan--they may be able to roll those never-been-taxed IRA dollars into their plan. That effectively removes those assets from consideration for the pro-rata rule, paving the way for little or no taxes to be due upon conversion of the new IRA to Roth. Another option: Those with self-employment income can steer their pretax IRA assets into a solo 401(k) plan--again, effectively removing them from the pro-rata calculation. This article discusses the workaround in detail.
Avoid By: Looking into whether your 401(k) or company retirement plan allows "roll-ins"--and making sure that its quality is up to snuff--before considering the backdoor maneuver if you have other Traditional IRA assets in the mix. This article provides some guidelines for evaluating your 401(k) plan.
Mistake 3: Not Taking Advantage of Escape Hatch #2
For investors who conducted a backdoor IRA maneuver that later proved regrettable because they had other, never-been-taxed IRA assets--and, therefore, the backdoor IRA had higher tax costs than expected--there's yet another escape hatch. They can recharacterize the conversion--that is, switch the newly converted Roth assets back to Traditional IRA status, which effectively undoes the conversion and any tax implications associated with it. After that, they could hang on to the Traditional nondeductible IRA or remove the pretax assets from the IRA kitty by rolling them into an employer's plan as described above and then have another go at a backdoor Roth IRA. The hitch is to adhere to the recharacterization deadline: Oct. 15 of the year following the year in which you made the conversion. The Bogleheads site has a detailed example with all of the notable dates.
Avoid By: Never assuming you've made an irrevocably bad decision about IRA contributions or conversions, as the recharacterization rules can help erase a multitude of mistakes. Just be sure to mind the deadlines.
Mistake 4: Investing the Traditional IRA in Long-Term Assets and Letting It Sit
The pro-rata rule isn't the only way to trigger taxes on the conversion from a Traditional IRA to Roth. If an investor opens a Traditional IRA and parks it in assets that quickly appreciate--such as stocks or a stock fund--and then tarries on the conversion, the conversion could trigger a higher-than-anticipated tax bill on that appreciation, which is taxed at ordinary income tax rates.
Avoid By: Keeping the money in a cashlike investment until the conversion is completed--thereby limiting the potential for gains in the preconversion window--and not tarrying on the conversion. Although tax experts disagree about how long one needs to wait between the time the Traditional IRA is open and funded and the conversion, a consensus seems to be building that a few days is plenty.
Mistake 5: Not Converting Serially
For affluent investors who are prime candidates for the backdoor IRA maneuver, a onetime backdoor IRA is likely to be a drop in the bucket relative to their other IRA assets--especially if they were shut out of Roth IRAs for many years prior to 2010. To really begin building their assets in their Roth accounts, they'll need to contribute year in and year out.
Avoid By: Making a habit out of executing a backdoor Roth IRA, and doing so at the beginning of each tax year rather than waiting until the last minute. Married couples can each conduct a backdoor IRA maneuver, and investors over 50 can contribute an additional $1,000 to any IRA, on top of the $5,500 base contribution.
Mistake 6: Holding Off Because of Concerns Over Legislative Risk
Many investors who have Roth assets--or are considering converting assets to Roth--have a nagging question: Could the tax-free withdrawals and no RMDs that Roth IRAs promise turn out to be too good to be true? That worry may be top of mind for high-income investors who want to take advantage of a backdoor Roth IRA. Even if Congress doesn't begin taxing Roth assets, it could put an end to the practice of converting aftertax assets held in a Traditional IRA to Roth. Indeed, President Obama's 2016 budget plan included just such a proposal.
That said, opinions are mixed about whether that proposal would gain the needed support in Congress; in the meantime, investors who avoid backdoor Roth IRAs because of legislative uncertainty are missing out on an opportunity to tuck more assets into the Roth column.
Avoid By: Monitoring the news flow on the future of backdoor Roth IRAs but continuing to execute the maneuver in the interim.