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Backdoor Roth IRA Conversions Alive and Well

Christine Benz

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Eight years after their arrival, backdoor Roth IRAs are alive and well. Joining me to discuss the maneuver is IRA expert Ed Slott. He is author of the newly revised "Retirement Decisions Guide."

Ed, thank you so much for being here.

Ed Slott: Great to be back here in Chicago.

Benz: We're thrilled to have you in the studio. One topic that comes up a lot with our readers and viewers on Morningstar.com is this idea of the backdoor Roth IRA. Let's talk about who should consider using the backdoor Roth IRA maneuver and really who doesn't have to consider it.

Slott: It's exactly as you say. It's a maneuver; it's a made-up term, backdoor Roth IRA. Here's the situation: It's a way to get money into a Roth IRA when you otherwise wouldn't qualify. Just to be clear, there's two ways to get money into a Roth IRA. The big money is in the conversions. You can convert $1 billion, if you had the money, and there's no income limits on that. But if you want to put $5,500 in a Roth IRA as a contribution, then we are going to lower the boom, then we want limits. This is out of control. Nobody knows why. Why do they have limits on such smaller amounts compared to the larger conversions. But that's where we are.

We are not talking about conversions, which are unlimited; anybody can do those. We are talking about the $5,500 a year Roth IRA contributions, or $6,500 if you are 50 or over. They do have income limits. Nobody knows the reason, but they have limits. It's not available to higher income taxpayers. The limits are relatively high for most people. There's a lot of people watching now that are over those limits that would like to make a Roth contribution. 

What developed over time has become known as a backdoor Roth or a workaround. And nobody liked that term, especially, we are just finding out now people at IRS, never liked those terms. There was a spokesperson that just came out recently and said, that was the only problem we had--we just didn't like the name.

Benz: Sounded illicit or something like that.

Slott: Here's how it works. You start with a traditional IRA. Why? Because unlike a Roth IRA contribution that has income limits, there are no income limits for who can contribute to a traditional IRA. Now, I'll just stop there because some people will say, no, no, there are income limits.

Benz: Absolutely, right.

Slott: That's only for deductibility if you are active in a company plan. But there are no income limits for who can contribute. You just may end up with a nondeductible IRA. That's all.

The process starts with a contribution to a nondeductible IRA, for which there are no limits. You can make $1 million a year and you can contribute the $5,500. Then you convert it to a Roth. Now, you are right back where you wanted to be. You have the same $5,500 or $6,500, in a Roth IRA, even though you are over the limits. Now, there was a lot of chatter about this over the years--that's illegal, you are getting to a place where the law says you are not allowed to be, people called it a step transaction and other illegal things. You don't have to worry about any of that anymore. I'm not even going to get into that. I was never in that camp by the way. I always thought it was fine.

Now, under the new tax law--this is not in the new tax law--but in the congressional conference report this--this backdoor Roth, not mentioned by name, but the actual procedure or the mechanism--is mentioned four times. Four times they state explicitly that this is allowable. They say you can make a contribution to a traditional nondeductible IRA and covert it to a Roth. IRS came out recently and said, if Congress says it's OK, we are good with it, we won't challenge it. And that's where the spokesperson who said that said, we really just were uncomfortable, we just didn't like the name.

Benz: There had been some advice out there in the past that you referenced. People had a sense, well, if I do this, I should wait between these two transactions--fund my traditional IRA and then perhaps wait a year even until I do this conversion. Is there a reason to wait around between these two transactions in your view?

Slott: Not anymore. But I was one of those people. I think, right on this program maybe a few years back I said--I never said wait a year--I always said, have it show up. Even today I might do that just for the tracing rules to see where it went. Have it show up, make your contribution to a traditional IRA. Wait till one statement, say, a month, so you can see it in the traditional IRA and then convert to a Roth. You don't have to, but if you want to see where it came in, you see it one account and then another, it's a clear path. It's absolutely legal. IRS won't challenge it.

There are cautions to it. Not everybody qualifies. And remember, this whole process starts with a contribution to a nondeductible traditional IRA. To make a contribution to a traditional IRA you have to be eligible. You can't just put money in just because IRS says the backdoor Roth is OK. You still have to qualify, which means you have to have earnings, W-2 income, self-employment income like you would to make any IRA contribution. 

Also, you can't be over 70 1/2, because currently, the tax rules say after 7001/2 you can no longer make traditional IRA contributions. It's odd because with the Roth, it's opposite. There is no age limit. 

There's a proposal now floating around Congress saying to eliminate that 70 1/2 rule. We'll see if that happens. But for right now, once you are over 70 1/2, this won't work for you. Because remember, the process starts with a contribution to a traditional IRA and if you are not eligible, you can't start the process. 

Also, you have to be aware because some people, I have seen even financial advisors say, this is a great thing, take your $5,500, put it in nondeductible traditional IRA, convert it to a Roth, no tax. That's not always the case. In fact, it's not the case for the most people. Most people have other IRA balances, including SEP and simple IRAs.

Benz: Traditional IRA balances.

Slott: Right. Right. For example, let's say, you want to do this with $5,000. You do a contribution to a nondeductible traditional IRA for $5,000, you convert it to a Roth. If your total IRA balance including all your other traditional IRAs is $100,000, then 95% of that conversion will be taxable. It's called a pro rata rule. You have to take the other funds into account. 

Now, it's not the end of the world because we are only talking about the tax on a $5,500 contribution or $6,500 contribution. The other thing is, this money goes in as a Roth conversion, not a contribution. There's a big difference here, but it's only a difference if you are under 59 1/2. With a Roth contribution when you put that contribution money in, you can withdraw it anytime, for any reason, tax and penalty-free.

Benz: The contribution itself.

Slott: Right. But not the conversion. The converted funds have to be held five years. And that's only if you are under 59 1/2 for the 10% penalty. If you are over 59 1/2, this makes no difference for you. It's just to keep in mind. if you are going through the effort of doing this, you are probably going to keep it for the five years anyway, why would you go through all this if you needed the money. But you never know.

Benz: You referenced that Congress has looked at harmonizing the rules about Roth and traditional IRAs. A question is, if this loophole is here and seemingly on the up and up, why doesn't Congress just officially bless it by lifting the income limits on Roth IRA contributions?

Slott: They should do it. Are you listening? Do they watch Morningstar? I mean, it seems like a no-brainer, especially when conversion money where all the big money is, there's no income limits. Why are there income limits? Just one of those things that got in the tax code and just never got out. You're absolutely right. Why don't they just get rid of all this and say, no more income limits for making Roth IRA contributions. 

Now, some people say that's another big break for the wealthy. But you are only talking about a $5,500 contribution or a $6,500 contribution each year. Why should there be income limits?

Benz: Ed, important topic. I know a lot of our viewers have been really interested in this backdoor Roth thing. Thank you so much for being here to clarify it. Thank you.

Slott: Thanks. Great to be here.

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