Note: This video is one of several interviews that Morningstar director of personal finance Christine Benz had with Vanguard officials at this year's Bogleheads event. See all of the interviews here.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Since 2010, many investors have been taking advantage of what's called a backdoor Roth IRA. Joining me to discuss what it is and who can benefit from it is Joel Dickson. He is Vanguard's global head of advice methodology.
Joel, thank you so much for being here.
Joel Dickson: Thanks for having me, Christine.
Benz: Joel, let's talk about this backdoor Roth IRA for people who haven't been paying close attention. What is this maneuver and why might it be advantageous for some investors?
Dickson: In short, the backdoor Roth IRA is a way to contribute to a Roth IRA for those that otherwise aren't eligible to make Roth IRA contributions. There are income limits to where you can make direct Roth IRA contributions. Roughly, if I'm going to recall off the top of my head, $133,000 for single individuals in 2018 and $189,000 for married filing jointly taxpayers, and that's on what's called modified adjusted gross income. If you are in excess of those amounts, you can't make a direct Roth IRA contribution. The backdoor Roth IRA contribution in essence is a two-step process that effectively gets to the same outcome of making a Roth IRA contribution on an annual basis.
Benz: Let's talk through the logistics. The idea is that I fund a traditional IRA and there's some confusion about who can fund a traditional IRA. Anyone can fund a traditional IRA, right?
Dickson: That's correct. You are right, there is often a lot of confusion. Anyone with any income level can fund a traditional IRA up to the $5,500 limit or $6,500 if you're age 50 or older. The question of eligibility in the traditional IRA is whether those contributions are tax-deductible or not. But anyone can make a traditional IRA contribution. It's just that if you're over certain income limits or if you have an employer-sponsored retirement plan, those contributions may not be deductible in taxes.
Benz: You fund the traditional IRA and then at some point, you convert the assets to Roth and essentially get those traditional IRA assets over to the Roth category, correct?
Dickson: That's correct. I should add one other caveat, which is that you need to have earned income in order to make contributions in the first place. But to do so, you would make a traditional IRA contribution and then after you have made that contribution, you convert that contribution or that amount from the traditional IRA to a Roth IRA. That is available because, and the change that was made in 2010, is it eliminated any income limit or restriction on making conversions of traditional IRAs to Roth IRA. Anyone regardless of income level can convert from a traditional IRA to a Roth.
Benz: Backdoor makes it sound a little bit illicit, but really the IRS has essentially blessed this maneuver, or at least indicated that it's OK for investors to do.
Dickson: Yes. Of course, interpreting IRS language of how to do it and when and so forth can be a little bit more challenging.
Benz: How long to wait and so forth.
Dickson: Yeah. There is some concern by some tax professionals that there needs to be a delay between when you make the contribution to the traditional IRA and then when you convert it to the Roth. There is, however, a lot of debate about whether a delay is needed; if so, how long of a delay and so forth. That's one where I think you have to seek out some guidance and have some sense from your own tax professional about what they might be comfortable with you doing.
Benz: The beauty of this, assuming I have this brand-new traditional IRA that I've funded and then I've converted before my investments have gained a lot in value, in those circumstances, converting really won't cost me a lot or maybe not even anything in terms of taxes. When can that conversion from my new traditional IRA to Roth in fact be taxable?
Dickson: You're right that you have to again get into the nuance of different tax considerations between traditional and Roth. From exactly that standpoint, I'll just give my own personal example. I do a backdoor Roth transaction every year. When I make a contribution, the initial contribution to the traditional IRA, I don't have other traditional IRA assets currently, and so, it ends up being nondeductible and I put it into a money market fund. Then, when I convert it, there's very little, if any tax liability because there hasn't been much of earnings that have occurred.
But for those that either have a long delay and maybe have put it in something that has earned some other return, there would be taxes based on the difference between the contribution amount and the conversion amount. More importantly and more applicably for many folks is when traditional IRA assets are converted to Roth IRA, either in full or in partial, the tax liability is determined on what's called a pro rata basis. You have earnings and tax liabilities from the traditional IRA that have to be included in total in the traditional IRA. For example, you can't just say I contributed $5,500 of after-tax dollars to a traditional IRA; I'm just going to convert that $5,500 to a Roth and not have additional tax liability. If that traditional IRA had another $5,500 that is all pretax money--
Benz: So, maybe I have a rollover IRA somewhere.
Dickson: Exactly--any conversion amount, whether it's $5,500 or $2,000 or the entire $11,000, half of it would be taxable and half of it would not. You can't just segregate the amount of the traditional IRA contribution that you want to convert in this backdoor process. It has to be done on a pro rata basis.
Benz: One workaround potentially is sometimes 401(k) plans or company retirement plans allow what are called roll-ins. You can maybe take those other IRA assets that would otherwise subject you to this pro rata rule and roll them into the company retirement plan?
Dickson: Yeah. There are all sorts of strategies that people will use, because that IRA pro rata rule just looks at IRAs. If you have otherwise taxable money, if it were to be converted or withdrawn, one strategy is, exactly as you mentioned, to potentially put those dollars into an employer-sponsored plan if your plan allows for it, and just leaving, if you will, the nontaxable portion, or not subject to further taxation, of what's in the traditional IRA and then converting it to the Roth.
Benz: I'd like to hear what Vanguard has observed in terms of the uptake of this maneuver. Are you seeing that investors seem to have a growing interest in doing the backdoor Roth IRA?
Dickson: I would say, it's very sporadic from what we see. Yes, there's interest in it; there is discussion about it. But in the data that we've looked at of our clients and so forth, I think it remains actually an opportunity for investors to take advantage of and at least assess whether it might make sense in their own long-term financial planning approach and situation.
Benz: Joel, always great to hear your thoughts. Thank you so much for being here.
Dickson: Thanks for having me, Christine.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.