Backdoor Roth IRA: Is It Worth the Effort?

Key Takeaways

• A backdoor Roth IRA is a mechanism that was born in 2010 when the government lifted what had been income limits on converting traditional IRAs to Roth. The basic idea is that you contribute to a traditional nondeductible IRA and then convert shortly thereafter to a Roth IRA.
• One of the reasons that gets tax and financial advice professionals so excited about the backdoor Roth is that in many cases there won’t be a tax bill associated with the conversion.
• It’s important to file Form 8606 along with your tax return in the year in which you do this backdoor maneuver. Form 8606 documents that you made this contribution and that it consisted of funds that have already been taxed.

Susan Dziubinski: I’m Susan Dziubinski with Morningstar. With tax day fast approaching, many investors have IRA contributions on the brain. Joining me to discuss the so-called backdoor Roth IRA is Christine Benz. She’s Morningstar’s director of personal finance and retirement planning, and the host of The Long View podcast. Thanks for being here, Christine.

Christine Benz: Hi, Susan. Great to see you.

Dziubinski: Let’s start out with the basic definition of what the backdoor Roth IRA is.

How Does a Backdoor Roth Work?

Benz: This is a mechanism, a loophole if you will, that was born in 2010 when the government lifted what had been income limits on converting traditional IRAs to Roth. And so financial planners, tax experts looked at this and said, “Huh, well, there is an income limit on direct Roth IRA contributions, but there’s now not any limit on conversions to Roth.” So the basic idea is that you are contributing to a traditional nondeductible IRA, and then you’re converting shortly thereafter to a Roth IRA.

Dziubinski: Got it. If I go to an investment provider’s website, I’m not going to be able to simply select backdoor Roth IRA as an option. There are a few steps involved in getting one of these set up. Talk a little bit about what those are.

Benz: You would fund a traditional nondeductible IRA, and you won’t see nondeductible IRA on your provider’s website, either. But if you are over the Roth IRA income limits, you’re automatically not going to be able to deduct that contribution on your IRA. So, you’re looking for a traditional IRA contribution. You make that contribution. There’s been some variation in expert opinion about how long to wait. I don’t think you need to wait that long. You could wait a couple of weeks, maybe a month, and then you’re converting to a Roth IRA. It’s typically just a quick process from there. And then, after that, I would wait to get the funds invested, leave them in a cash account. After that, when they are fully ensconced in your new Roth IRA, then I think you can go ahead and get the funds moved into whatever investments that you might choose to hold for the long term.

Roth IRA Conversion and Tax Implications

Dziubinski: Normally, when people hear the IRA conversion, they might think about taxes being due. What are the tax implications here?

Benz: Well, the beauty of this, and one of the reasons that gets tax and financial advice professionals so excited about this backdoor Roth, is that in many cases there won’t be a tax bill at all associated with the conversion. Maybe to the extent that there is, it might be quite modest, and there are exceptions, which I’ll cover in a second. But the basic idea is if you are putting the funds into the traditional IRA, you’re putting in aftertax dollars. As I said, you can’t deduct that on your tax returns. So, these are aftertax dollars going in. That money can’t be taxed again. And then assuming that you don’t invest in anything that gains in value between the time you make that contribution and do the conversion, there shouldn’t be any taxes due there, either. That’s why for many people this will be a tax-free or nearly tax-free maneuver.

There is a big exception though, which is for folks who have substantial traditional IRA assets, in addition to this backdoor thing that they’re doing, if they have substantial traditional IRA assets, the blended bucket of IRA assets is subject to what’s called the pro rata rule, which means that when you do conversions or take distributions eventually, the tax treatment of the conversion in the case of this backdoor Roth IRA, will depend on the ratio of never-been-taxed assets to assets that have been taxed. So, if the bulk of my IRA is in rollover assets that have never been taxed where I’ve been making pretax contributions, I haven’t done anything to trigger any tax bill, well, there, when you do the conversion of your small new Roth IRA through the backdoor, you may actually face a tax bill. Just get some tax advice if this situation describes you, if you do have substantial rollover IRA assets that have never been taxed.

Avoiding Taxes and the Pro Rata Rule

Dziubinski: Is there a way to avoid taxes if someone has those substantial traditional IRA assets and they still want to make the backdoor contribution?

Benz: Yes, and this is where if you’re someone who is covered by a company retirement plan, and that plan allows what are called roll-ins where it will take funds from an IRA or perhaps from another employer, and this will depend on how your 401(k) plan’s bylaws are written, but it may allow you to roll those assets into the 401(k) plan where they will not be subject to the pro rata rule. But you want to do your due diligence in addition to just checking that your plan offers this feature. You really want to be thinking about how good it is because you’re making a pretty big sacrifice to get this small backdoor Roth IRA up and running. So, the main thing that you’d need to do your due diligence on is: Is this a good 401(k) plan where I want all of these assets?

Cash vs. Traditional Roth IRA

Dziubinski: Got it. Makes sense. Should someone wait until the assets are in the Roth to actually invest the money? I think that’s what you said at the beginning of our conversation. So, it’s a better idea to keep it in cash, in the traditional Roth?

Benz: That’s how I personally have been proceeding. I’ve been doing this process for a good 10-plus years now. I have been making the traditional IRA contributions, not getting them invested, and then waiting until the funds are finally in the Roth IRA to get them invested. I know there are different schools of thought on this, but that’s how I’ve been proceeding mainly because my goal is to try to reduce that tax drag. If I do hit the jackpot and invest my traditional IRA assets in something that performs really well before I get around to doing the conversion, well, that could trigger a bigger tax bill than I might care to be on the hook for.

Backdoor Roth Tax Form: Form 8606

Dziubinski: Backdoor Roth IRA contributors have to fill out a specific form, 8606. What is the form? Why is it important?

Benz: It’s important to file along with your tax return in the year in which you do this backdoor maneuver. And basically, this Form 8606 is documenting that you have made this contribution and that that contribution consisted of funds that have already been taxed. By doing this, by filing this with your return, you’re providing a paper trail so that when you eventually begin to tap the funds in that Roth IRA and you want to earn that nice tax-free withdrawal treatment, you have documentation that those contributions going in were aftertax dollars, meaning that they’re not going to get taxed again. It’s a key tax form that you want to make sure that you are doing, that you’re filing in addition to doing the logistics that we’ve already talked about.

Dziubinski: Christine, thanks for walking us through some of the complexity here, but seeking some tax advice on this is a good idea, too.

Benz: Backdoor Roth is alive and well.

Dziubinski: Thanks for your time, Christine.

Benz: Thank you, Susan.

Dziubinski: I’m Susan Dziubinski with Morningstar. Thanks for tuning in.

Watch 5 Little-Known Rules About IRA Contributions for more from Christine Benz.