Is the Backdoor Roth IRA Worth the Trouble?

This article, the first of a three-part series on how to implement an effective backdoor Roth strategy, was written by guest contributors Steven Jarvis, CPA, MBA, and Matthew Jarvis, CFP.

Financial advicers—those advisors who are in the business of providing financial advice and who create value through the advice they give (and not through the sale of particular products)—are always on the lookout for planning opportunities and strategies that will help clients achieve their financial goals. As an added benefit, these strategies help demonstrate the ongoing value that advicers provide to clients in exchange for the fees they charge. However, regular consumers of technical content can sometimes become desensitized to the strategies that “everybody already knows,” sometimes to the point of taking them for granted, or worse yet, overlooking the detailed nuances that make the strategies effective and implementing them incorrectly.

One such strategy includes the seemingly universally known backdoor Roth strategy, which involves the conversion of funds in a traditional IRA into a Roth IRA, benefiting taxpayers who may be ineligible to make direct contributions to a Roth IRA (for example, individuals whose income levels exceed the Roth IRA threshold limits). After all, this strategy has been around for years, and it seems that every financial planning author, journalist, blogger, podcaster, and social-media influencer has produced content on the topic.

However, despite this being a universally known strategy, in Steven’s role as a CPA and tax preparer, he reviews hundreds of returns each year, many from clients with advisors who have missed this opportunity or who have implemented it incorrectly, which, if left uncorrected, will result in unnecessary headaches, taxes, and even penalties (all of which have the compounding effect of diminishing the advisors’ value to their clients).

When the Backdoor Roth Is Worth Doing

Before reviewing the rules and strategies for using the backdoor Roth strategy, let us first address the concern raised by many advisors, clients, and tax preparers, which is some variation of, “This sounds like a lot of work for $6,500!” Actually, many tax preparers will likely say something like this to their clients: “Your advisor made this big mess of your taxes, and you don’t even get to deduct it! If you had just made an IRA contribution, you would have saved thousands in taxes.” (This is an actual quote from a tax professional!)

Going around to the backdoor makes sense when you can’t get in through the front. Making backdoor Roth contributions is an extension of the broader decision that going with a Roth makes sense for a particular taxpayer. For taxpayers who are concerned they will be in a higher tax bracket in the future, either because their income increases or because tax laws change, backdoor Roth contributions can be a great tool for filling up their tax-free bucket. Advisors should first explore contributory Roth options through employer-sponsored retirement plans (which don’t have the income limits that Roth IRAs do) and verify the taxpayer can’t make direct Roth IRA contributions before beginning backdoor Roth contributions.

To help both clients and tax preparers understand the backdoor Roth strategy value of “just” $6,500 annually, financial advisor Michael Henley illustrates how advisors could open the conversation as follows:

Ms. Client, whereas your tax preparer is focused almost exclusively on last year, one of my jobs is to keep you ahead of the IRS for decades.

If my team coordinates backdoor Roth contributions of $6,500 for you in each of the next 20 years, and let’s say (for easy math) that it grows at 10% annually, we could have a tax-free bucket of some $370,000. Which, in round numbers, would save you some $50,000 in taxes.

Would it be OK with you if my team takes care of this for you, even if it requires you to sign a couple of forms?

Whereas a client or tax preparer may understandably feel that $6,500 is hardly worth the effort, knowing it can cumulatively add up to a tax-free bucket of $370,000 (double, if married) suddenly feels very inspiring. However, even the most beneficial tax strategy only counts if the advisor can get the client to take the action required to implement the strategy.

The Backdoor Roth Strategy Sounds Great, but What Exactly Is It?

It’s important to first acknowledge that the backdoor Roth IRA contribution is not officially a “thing,” at least not to the IRS, but rather a tax loophole that the IRS and Congress know about but have chosen not to close. (Thankfully, the IRS has acknowledged that taxpayers are using this strategy and has not made any focused effort to prevent or crack down on it.)

More specifically, the backdoor Roth IRA strategy consists of a two-step process involving 1) a contribution made to a traditional IRA, followed by 2) conversion into a Roth IRA. This process is designed to get annual contributions into a Roth IRA for taxpayers whose income levels surpass the Roth IRA contribution phaseout range, precluding them from making these contributions. For 2023, the income phaseout for a taxpayer (married filing jointly) making contributions to a Roth IRA ranges from $218,000 to $228,000 of Modified AGI (reported on Form 1040 Line 11, with some adjustments).

Individuals who are covered by an employer’s retirement plan and whose income exceeds certain levels (limiting the amount they are able to deduct for their contribution to a traditional IRA) use the backdoor Roth IRA strategy by making nondeductible contributions to an IRA, which add a level of complexity to the process as addressed in the following sections. However, Backdoor Roths can also involve deductible contributions made to a traditional IRA (for example, for those who make too much to contribute directly to a Roth IRA but who are not an active participant in an employer retirement plan). The net result would be the same (the taxpayer gets a pretax deduction on their contribution, and then the conversion is counted as taxable income, the income is offset by the deduction, and the net tax result is the same aftertax Roth contribution equivalent), but the scenario is simpler (no aftertax dollars to report, track, and so on).

While these income limitations apply to contributions made to a Roth IRA, there are no such limitations on contributions made to a traditional IRA. Furthermore, what makes the backdoor Roth IRA strategy work is that while Roth IRA contributions have income limitations, Roth IRA conversions do not (since the conversion income limits were repealed effective in 2010).

Here’s an example:

Bob and Sue are clients whose modified adjusted gross income of $250,000 puts them well over the top of the Roth contribution phaseout for married filing jointly taxpayers.

Their advisor says: “Bob and Sue, for reasons unknown to me, Congress has decided that you make too much money to take advantage of the tax-free benefits provided to everyone else by a Roth IRA. However, there is still great news: Congress has left open a ‘backdoor,’ which still allows us to contribute to a Roth account each year, albeit with an extra step, sometimes known as a backdoor Roth contribution.”

While there are several critical variables (which will be discussed later) for advisors to consider when determining whether the backdoor Roth strategy will make sense for a client whose ability to make deductible IRA contributions is limited, the first step of the strategy is basically accomplished by the taxpayer contributing up to the annual limit ($6,500 in 2023, plus a $1,000 catch-up over age 50) into a traditional IRA and designating the contribution as nondeductible.

By virtue of being nondeductible, these funds are now viewed by the IRS as aftertax dollars. The contribution amount, or basis, can be withdrawn tax-free (restrictions and penalties on IRA distributions still apply). Again ignoring critical variables, the second step is for this tax-free money to be converted, tax-free, into a respective Roth IRA.

Back to our example.

Bob and Sue agree to proceed with the backdoor Roth strategy suggested by their advisor.

Their advisor instructs Bob and Sue each to contribute $6,500 into nondeductible traditional IRAs and then convert those funds into their Roth IRAs.

The result is that Bob and Sue each now have $6,500 in their respective Roth accounts, despite being ineligible to make direct contributions to those accounts because their income is too high.

Sounds Easy-Ish, but What Are the Critical Variables Involved?

While a backdoor Roth contribution may sound straightforward in principle, there are many reporting requirements for nondeductible IRAs (through IRS Form 8606), and numerous IRS rules around timing and accounting that can quickly turn this seemingly simple strategy into a literal lifetime of headaches and painful reminders if screwed up.

These issues are compounded by the major custodians being unable to track the nontaxable basis portion in the account (which is why most 1099-R Forms—which report distributions made from IRAs and other accounts—have Box 2b checked to signify “Taxable amount not determined”), which makes it even easier to mess up the whole process!

In our next article, we’ll discuss many of the common roadblocks that can complicate the backdoor Roth strategy.

Steven Jarvis, CPA, MBA, is the CEO and head CPA at Retirement Tax Services, a tax firm focused on working with financial advisors to change the world one tax return at a time.

Matthew Jarvis, CFP, is the owner and lead advisor of Jarvis Financial Services.

This article first appeared on the Nerd’s Eye View at Kitces.com and has been reprinted here with permission. The views expressed here are the authors’.