Backdoor Roth IRAs: What You Need to Know
Understand the 'pro rata' rules, the logistics, and the long-term viability of this maneuver.
Note: This article is part of Morningstar's Tax Relief Week. A version of this article appeared on Jan. 8, 2017.
The Tax Increase Prevention and Reconciliation Act of 2005 extended several popular provisions of the Jobs and Growth Tax Relief Reconciliation Act of 2003. Not only did TIPRA renew the low tax rates on qualified dividends and long-term capital gains rates that so many investors hold dear today (it seems like a lifetime ago that dividends were taxed at ordinary income tax rates!), but it also lifted the income restrictions for converting a traditional IRA to Roth, starting in 2010. Before 2010, you could only convert traditional IRAs to Roth if your adjusted gross income was below $100,000.
And with the lifting of those income limits--but not the income limits governing who can contribute to a Roth IRA directly--the "backdoor Roth IRA" was born. The backdoor Roth IRA strategy is often touted as an easy way for high-income folks who are otherwise shut out of direct Roth IRA contributions because they earn too much to get at least some assets into the Roth column without having to pay a big tax bill. The basic idea is to fund a traditional IRA, for which there are no income limits (assuming you're not deducting the contribution), then convert to a Roth--again, no income limits thanks to TIPRA.
That sounds simple enough, but there's still plenty of confusion about backdoor Roths. Who should consider one, and who shouldn't bother? What are the tax implications? And importantly, could this loophole eventually go away, and what would happen if it did?
What follows are some frequently asked questions about the backdoor Roth IRA maneuver.
Q: Who should consider a backdoor Roth IRA?
A: People who cannot contribute directly to a Roth IRA because they earn too much are prime candidates for backdoor Roth IRAs. For 2017, single filers with less than $118,000 in modified adjusted gross income and married couples filing jointly with less than $186,000 in MAGI can make full, direct Roth IRA contributions. They can make partial direct Roth IRA contributions if their incomes fall between $118,000 and $133,000 for single filers and $186,000 and $196,000 for married couples filing jointly, but it's hard to see why they'd bother; the backdoor Roth IRA gives them the latitude to make a full IRA contribution of $5,500 if they're younger than 50 or $6,500 if they're 50-plus.
Q: Forget backdoor. What's the big deal about Roth IRAs in the first place?
A: The tax treatment of a Roth IRA is almost exactly opposite of the tax treatment of a traditional IRA. With a traditional IRA, you get a tax break at the time you make your contribution (assuming your income is below the thresholds to make a deductible contribution) but pay ordinary income tax on your money when you pull it out in retirement (save for dollars that you’ve already paid taxes on). With a Roth IRA, you put in money that you've already paid tax on, but you're able to take your money out tax-free during retirement.
If you knew your tax rate would be the same when you took your money out in retirement as it was when you made the contribution, it wouldn't matter whether you made a Roth or traditional IRA contribution. It's a wash. The virtue of Roth contributions, however, is that if your tax rate is higher when you take the money out in retirement--either because your income is higher than it was at the time of your contribution or because tax rates have gone up secularly since then--you'll be glad you made Roth contribution. Another big benefit of Roth IRAs is that they don't carry required minimum distributions, unlike traditional IRA assets. Thus, they can be ideal accounts for your heirs to inherit: Not only will you not have to draw down Roth accounts in your lifetime, but your heirs can inherit them free of federal taxes. (Estate taxes may apply, however.)
Finally, there's a logistical reason that higher-income folks often fund Roth IRA accounts: the income limit on direct Roth contributions is higher than is the case for traditional deductible IRAs, and the backdoor maneuver is open to investors of all income levels.
Q: I've always heard that IRA conversions mean a tax bill. Won't that be the case if I open a traditional IRA and then convert it to Roth?
A: You're right that an IRA conversion can often trigger a tax bill. If you deducted your contribution on your tax return and/or your investments have made money since you purchased them, when you convert those assets to a Roth IRA you'll owe taxes on your contribution, your investment gains, or both.
In the case of a nondeductible contribution, however, you're putting in money that you've already paid taxes on, so you won't owe taxes on it again. Moreover, if you convert your new traditional IRA account to Roth before your investments have made any money, you won't owe taxes on investment appreciation, either. That's why the backdoor Roth IRA can be a tax-free or nearly tax-free maneuver for many investors.
Q: You say the backdoor Roth IRA can be a tax-free or nearly tax-free maneuver for many investors. Why not all investors?
A: The key reason a backdoor IRA could be taxable is what's called the pro rata rule for IRA conversions. That means that for the purpose of calculating the tax you owe for the year of the conversion (and at the time you pull your money out in retirement, too), you need to look at the tax complexion of all of your IRAs in aggregate. If you have additional IRA assets that you've never paid taxes on (consisting of pretax contributions and/or investment gains) the ratio between your never-been-taxed IRA assets and your already-been-taxed IRA assets will determine your tax bill at the time you convert your IRAs.
Let's assume a person who earns $200,000 a year and has $20,000 in traditional IRA assets rolled over from a former employer's 401(k) puts $5,000 into a traditional nondeductible IRA, seeking to take advantage of the backdoor option. At first blush, it seems like this converter shouldn't owe any taxes, either. Her contribution to the new IRA was already taxed, and if she makes the conversion right away, before her investment goes up in value, she wouldn't owe any taxes on investment gains, either.
But here's where the pro rata rule comes in. Her other traditional IRA assets consist entirely of money that she had rolled over from an old 401(k) plan, meaning that money has never been taxed.
Because of those other IRA assets, the tax she'll owe upon conversion will depend on percentage of taxable versus tax-free assets in all of her IRA accounts, not just the one she just opened.
In her case, $20,000 of her IRA assets haven't yet been taxed totals and her new nondeductible IRA contribution of $5,000 already has. That means that 80%, or $4,000, of her recent $5,000 contribution would be taxable upon conversion; only $1,000 (the other 20%) would not be.
All of this means that if you have other traditional IRA assets, or SEP and SIMPLE IRAs, you'll need to proceed carefully before opening up a traditional nondeductible IRA with an eye toward immediately converting to a Roth.
Q: Do my 401(k) assets count in the pro rata calculation? They've never been taxed, either.
A: No. Any company retirement plan assets, whether 401(k), 403(b), or 457, are considered distinct from the IRA assets. They wouldn't affect the taxation of any IRA conversion.
Q: Is there any way around the pro rata rule if I have other traditional IRA assets?
A: Participants in 401(k) plans that allow external assets to be rolled into the plan can roll their traditional IRA assets into the plan, effectively removing them from the pro rata calculation. This maneuver is only advisable if the 401(k) plan is low-cost and high-quality, however. This article takes a closer look at that workaround.
Q: How complicated are the logistics of a backdoor Roth IRA?
A: Not very. The first step is to contribute to a traditional IRA. You'll also need to file IRS Form 8606, specifying that you made a nondeductible IRA contribution, for the tax year in which you made the contribution. When you eventually convert the assets to Roth from traditional you'll need to fill out a form with your investment provider. You'll also need to indicate the amount you converted, and the amount of the conversion that was taxable, on your tax return for the conversion year (line 15a on form 1040; note that in the IRS' eyes, your conversion is considered a "distribution"). And if you don't already have a Roth IRA, you'll need to set one up so that it can "receive" the assets. Finally, once the Roth IRA is established, you'll need to specify what you'd like the money invested in.
Q: How long after initially funding my IRA do I have to wait to convert?
A: That's a subject of some debate. Financial planning guru Michael Kitces urges a cautious tack, arguing that would-be backdoor Roth IRA investors should wait a year between the initial funding of the IRA and the conversion to Roth. Meanwhile, IRA experts Ed Slott and Jeffrey Levine believe that investors needn't wait a protracted period of time to conduct the conversion. My own two cents is that because backdoor IRA funders are subject to the annual contribution limits of $5,500 ($6,500 if over 50)--not huge sums of money--it's hard to imagine the IRS taking a very aggressive tack in going after backdoor Roth IRA investors, even if Congress didn't intend for investors to take advantage of the loophole. More likely, Congress would close the loophole on a going-forward basis, as discussed below.
Q: Should I invest the money in my traditional IRA in long-term assets, or leave it in cash until I do the conversion?
A: Here's another area where expert opinions vary. The virtue of leaving the money in cash is that with cash yields close to nil currently, there will be a limited chance of investment appreciation in the traditional IRA between the time the account is funded and when the conversion occurs. That limits the possibility that the conversion will be taxable in any way. On the other hand, Kitces urges a more cautious approach, suggesting getting the traditional IRA assets invested in long-term assets; that demonstrates that the investor actually intended to invest within the traditional IRA and wasn't simply trying to skirt a loophole.
Q: Could Congress clamp down on this maneuver? And what would happen if it does?
A: This is the $64,000 question. Congress has put limits on tax-sheltered investment options in an effort to limit their use by very high-income investors; the Roth IRA maneuver runs counter to the spirit of those limits. Further limiting the appeal of the backdoor IRA in the eyes of Congress is that, unlike other IRA conversions, a correctly executed backdoor Roth IRA is unlikely to bring new tax revenues in the door. Indeed, President Barack Obama's budget for the past few years has included proposals that would effectively kill the backdoor Roth IRA by allowing only pretax dollars in retirement accounts to be converted to Roth. (Investors going into a Roth through the backdoor are doing so with aftertax dollars.) On the other hand, a Republican-led Congress may have less of an appetite to kill a tax-saving option that's appealing to high-income investors. And in any case, it's highly unlikely that any new legislation will have any impact on assets that have already been converted to Roth.