Backdoor Roth IRA

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I have a rainy day fund, I have been maxing out my 401K at work, and I have been putting money into a 529 college savings plan for my kids for years. I thought that was all you were supposed to do and all that you could do as a W2 employee collecting a paycheck from a company. I always thought that if you contributed to a 401K at work and you made over a certain amount, then you could not contribute any additional money to a personal IRA.

But a few years ago when I started making my personal finances more of a priotiy, I learned that, even if you earned above the income limits for a deductible IRA abd Roth IRA, you can still contribute to an IRA. It won’t be a traditional “deductible” IRA where you get a current year tax deduction. Instead, it will be a traditional “non-deductible” IRA that, like a deductible IRA, allows your contributions to grow on a tax-deferred basis, but only your gains will be taxed as income when you make withdrawals during your retirement years. I also learned that you can follow-up your contributions by doing a “backdoor” Roth conversion to transform your non-deductible IRA into a Roth IRA.

A Roth IRA is a very powerful vehicle. All things being equal, a Roth is much better than a traditional IRA because your contributions will grow tax-free and, more importantly, your withdrawals during your retirement years will also be tax-free, whereas, withdrawals from your traditional IRAs are taxed as income. The reason why a Roth is tax-free is because you pay the taxman upfront via your income taxes and, therefore, are using after-tax dollars for your contributions. With a traditional “deductible” IRA, you are using pre-tax dollars, for which you will eventually need to pay taxes. And the time when the tax bill finally comes due is when you make your withdrawals. So I personally like Roth for the flexibility that the tax-free withdrawals provide. Who knows what your situation is going to be and what the tax structure is going to be like when you retire, so I also like having a sizeable chunk in Roth-like accounts to help diversify your future tax exposure.

How Does a “Backdoor” Roth Conversion Work?

In a Roth conversion, you pay taxes only on gains above your cost-basis. For a traditional deductible IRA, you cost-basis is zero since you never paid any taxes on your original money. But, if you make a non-deductible IRA contribution, you are actually contributing after-tax dollars to your traditional IRA. What this means is that your contribution is your cost-basis. So, if you make a $5,500 contribution and do an immediate conversion to a Roth, the value of your non-deductible IRA would still be the same value as your contribution and, thus, you would owe zero taxes because you had zero gains ($5,500 – $5,500 = $0). And that’s the formula you would follow every year: make a non-deductible IRA contribution and then immediately convert it to a Roth IRA for tax-free growth and tax-free withdrawals (after age 59 ½).

So, if you plan to do this over the next 20 years, you will make $110,000 (20 x $5,500) of Roth contributions that will grow tax-free (not just tax-deferred) and be tax-free when you make withdrawals (after age 59 ½). If you start doing this every year at age 45 and earn an average annual rate of return of 7.2%, your Roth IRA would grow to be $247,054 by the time you are 65. Double it again to $495,154 if you start 10 years earlier (i.e., the power of compounding). Double these amounts if your spouse makes the same contributions.

Well, that was the “clean slate” example. The “backdoor” Roth conversion is not as straight-forward if you have existing IRA accounts and personal 401K rollover accounts (which are also considered IRAs), which many of us do. The Roth conversion is complicated by what is called the pro-rate rule, which we will discuss in the next section. If you make below some of the income limits, you may be able to invest directly in a Roth. We’ll breakdown the income limits later in this article too.

Roth Conversion Pro-Rata Rule

An article I read called “The Power of the Backdoor Roth IRA” in US News & World Report does a great job explaining this as well as the backdoor Roth in general. To paraphrase, the pro-rate rule requires that you group all of your traditional IRAs (deductible and non-deductible and including your personal 401K rollovers) into one big bucket, and pay a proportionate amount of taxes on the amount you are converting to a Roth IRA. You do not get to “cherry-pick” the IRA accounts you are converting. They all must be lumped together for the pro-rata calculation. I think it’s best explained with some numerical examples.

  1. You have a clean slate. You have no other traditional IRAs or 401K rollovers. If you make a new $5,500 non-deductible IRA contribution this year, you would have a cost-basis of $5,500. The new $5,500 IRA is 100% of your total IRAs ($5,500 / $5,500 = 100%), so, therefore, 100% of the cost-basis would be assigned to it (100% * $5,500 = $5,500). If you converted the new IRA account of $5,500 into a Roth, you would owe zero taxes because you have zero gain ($5,500 – $5,500 = $0).
  2. You currently have IRA accounts worth $49,500 made up of both deductible and non-deductible contributions. The original non-deductible contributions (not the current account value) you made in years past totaled $22,000 and is your total cost-basis. If you make a new $5,500 non-deductible IRA contribution this year, the new total for traditional IRAs would be $55,000 ($49,500 + $5,500) with a new cost-basis of $27,500 ($22,000 + $5,500). If you converted only the new IRA account with $5,500 into a Roth, its pro rata share of the total IRA bucket would be 10% ($5,500 / $55,000 = 10%), so only 10% of the cost-basis would be assigned to it (10% * $27,500 = $2,750). With the conversion, you would owe taxes on the $2,750 gain ($5,500 – $2,750 = $2,750) at your marginal tax rate. If you are using the backdoor Roth strategy, you would be in the 28% or higher tax bracket up to 39.6%. Assuming 28% rate, you would owe $770 (if you converted $5,500) or $7,700 (if you converted 100% of your IRAs) in taxes.
  3. You currently have deductible IRA accounts and a 401K that you rolled over into an IRA that total $104,500 in value. Since these are all deductible IRAs made with pre-tax contributions, you have zero cost-basis in them. If you make a new $5,500 non-deductible IRA contribution this year, the new total for traditional IRAs would be $110,000 ($104,500 + $5,500) with a cost-basis of $5,500 (for the new non-deductible contribution). If you converted only the new IRA account with $5,500 into a Roth, its pro rata share of the total IRA bucket would be five percent ($5,500 / $110,000 = 5%), so only five percent of the cost-basis would be assigned to it (5% * $5,500 = $275). With the conversion, you would owe taxes on the $5,225 gain ($5,500 – $275 = $5,225) at your marginal tax rate. If you converted 100%, your marginal tax rate would move up to at least 33%. Assuming 33% rate, you would owe $1,724 (if you converted $5,500) or $34,485 (if you converted 100% of your IRAs) in taxes.

With example 1, you pay no taxes to convert to a Roth, so it’s a no-brainer.

If you have significant amount of assets in non-deductible IRAs like example 3, then it’s more of a “is a Roth conversion right for me?” question in general since you will have significant upfront tax consequences.

If you have some, but not a lot of, deductible IRA assets like example 2 and you have a longer-term view (e.g., I’m going to contribute $55,000 over the next 10 years, so longer-term tax-free benefits outweigh paying taxes on a $20,000 gain over the next couple years), then you might do the Roth conversion in one (to create a clean slate) or spread over a few years (if taxes are on the higher side).

Key Considerations

If you are considering executing the backdoor Roth strategy going forward, then you should not roll over any of your 401Ks into a traditional IRA. 401Ks are pre-tax contributions with zero cost-basis and the entire amount of the 401K rollover would be considered a gain. Either keep your 401K at your current employer (i.e., do nothing; you can keep it there even if you leave the company) or roll it into your new employer’s company-administered 401K account.

If you are married, you and your spouse are considered two separate individuals (IRAs are not co-mingled between you two). What that means is that the taxes on your Roth conversion (and pro-rate rule) only consider your own IRA accounts. Likewise, your spouse’s conversion calculations only consider his/her own IRA accounts. This means that you can make different decisions based on your and your spouse’s individual situations.

The current (2015 and 2016) yearly IRA contribution limit is $5,500 if under 50 years old, and $6,500 if 50 years and older (higher for catchup). However, if you did not make an IRA contribution in the prior year and it’s still before April 15th, you can make a contribution for 2015 (before April 15th) and a separate, additional contribution for 2016. Make sure you specify the contribution years to your brokerage firm.

You can make only one Roth conversion per year. If you are contributing small amounts to an IRA every month, then you may need to wait until you have aggregated your annual amount until you execute the formal Roth conversion.

Tip: You also might want to open a new IRA account for your new annual non-deductible IRA contributions. While all of your traditional IRA accounts are totalled together for the pro rata rule calculations, it does make record-keeping slightly easier.

And it goes without saying, but always check with your tax advisor about the tax consequences for any major financial moves you are considering.

How It’s Working in Real Life

For my situation, the backdoor Roth strategy worked for my wife but didn’t work for me. Again, since we are two individuals, the pro rata rule and conversions are calculated on an individual basis.

Most of my wife’s retirement assets are in employer-administered 401Ks with a small amount in personal IRAs. This was similar to example #1 and #2. So, we converted her existing IRAs to create a clean slate and, consequently, had to pay a small amount of taxes for the Roth conversion. Now going forward, we expect to benefit from future non-deductible contributions and tax-free conversions over the next couple decades.

For me, I have a higher portion of my retirement in deductible IRAs, which means that I would have a significant tax burden upon conversion. So I decided not to do the backdoor Roth conversion. I am, however, still contributing to a non-deductible IRA every year when I can. In addition to taking advantage of tax-deferred growth for my retirement, this also plays well with our college planning of moving our “regular” assets to “retirement” assets, which are excluded from college financial aid calculations. But that’s another topic for another time.

Checklist and Action Items (can you tell I was a consultant?)

To summarize, even if you have a 401K at work and if you can afford it, you should still contribute to an individual IRA every year to take advantage of tax-deferred growth. If you are above the income limits and covered by a retirement plan at work (over $193,000 married, filing jointly or $131,000 single), you can contribute to a non-deductible IRA and then follow the steps to do a backdoor Roth conversion. If you are close to these limits, you may be able to contribute to a Roth IRA directly (more information for this scenario later in the article).

  1. Determine your IRA contribution limits based on your modified adjusted gross income (MAGI). Use this a quick calculator for IRA limits. Also below is a table of 2015 income limits break points (links to IRS tables are in the “Key Terms, Resources, and Articles” section at the end of this article).
    • Single with a retirement plan at work.
      • MAGI is less than $61,000, then you can contribute fully to a deductible IRA or directly to Roth IRA.
      • MAGI is between $61,000 and $71,000, the deductible IRA phases out, but you can still contribute fully to a Roth IRA.
      • MAGI is between $71,000 and $116,000, you can contribute directly to a Roth IRA. You can also contribute to a non-deductible IRA, but the point of this is to get your dollars into the Roth.
      • MAGI is between $116,000 and $131,000, the Roth IRA phases out.
      • If your MAGI is above $131,000, then you can only contribute to a non-deductible IRA.
      • Single but not covered by a retirement plan at work. The Roth IRA income limits are the same as Single with retirement plan at work. However, there is no income limit for contributing to a deductible IRA.
    • Married, filing jointly with a retirement plan at work.
      • MAGI is less than $98,000, then you can contribute fully to a deductible IRA or directly to Roth IRA.
      • MAGI is between $98,000 and $118,000, the deductible IRA phases out, but you can still contribute fully to a Roth IRA.
      • MAGI is between $118,000 and $183,000, you can contribute fully and directly to a Roth IRA. You can also contribute to a non-deductible IRA, but the point of this is to get your dollars into the Roth.
      • MAGI is between $183,000 and $193,000, the Roth IRA phases out.
      • If your MAGI is above $193,000, then you can only contribute to a non-deductible IRA.
      • Married, filing jointly but not covered by a retirement plan at work. The income limits for the non-deductible IRA move up to the same level as the Roth income limits ($183,000 with phase outs through $193,000).
  2. If you make less than the Roth IRA limits, then you can contribute directly into a Roth without the need for a backdoor Roth conversion. Determine if you want to make deductible IRA contributions or Roth contributions directly and develop your plan around that. Skip to step 10 on checklist.
  3. If you make more than the Roth income limits, then continue.
  4. Calculate the current value, cost basis and total current gain you have for all of your traditional IRA accounts. Add up the current value for all of your traditional IRAs (deductible and non-deductible and 401K rollovers) and obtain the cost-basis (Form 5498 IRA contribution information from your brokerage firm). Subtract the cost-basis from the current value to determine your current gain on your IRAs.
  5. Estimate any current year tax consequences from a Roth conversion. An increase to your income will increase your taxes by your marginal tax rate. Look up your marginal tax rate (tax bracket calculator) for the conversion year and multiply that by the pro-rata share of the gain you will be converting to estimate the additional taxes you will pay for the current year.
  6. Determine if doing a conversion (full or partial) of your traditional IRAs makes sense. You can use this Roth IRA conversion calculator as a starting point, which calculates what your future monthly after-tax income would be under a Roth conversion vs. maintaining a traditional IRA. This is a snapshot of your current IRAs and does not take into account your future IRA contributions along with the backdoor Roth conversion strategy. If the additional years and amounts that you will contribute outweigh your IRA value by an order of magnitude, then it probably makes sense to do the Roth conversion.
  7. Develop your plan. Determine what portion you will be converting and over how many years.
  8. Start contributing ($5,500 if 49 or younger, or $6,500 if 50 or older) to an IRA for 2016. If you did not make a contribution during 2015, then you can make a similar contribution for the prior year before April 15th. Make sure to specify the contribution years with your brokerage firm.
  9. Make your backdoor Roth conversions according to your plan. Remember, you can make only one Roth conversion per year.
  10. Repeat every year according to your plan.

Again, always check with your tax advisor for major financial decisions that may affect your taxes.

Key Terms, Resources, and Articles

A Traditional IRA is a tax-deferred retirement vehicle. You do not pay taxes on interest income and gains during current years. Instead, you pay income taxes when you start withdrawing money from those accounts when you are retired and your tax bracket is expected to be much lower (there are penalties for withdrawals before age 59 1/2). 

  • You are required to make withdrawals beginning in the year you turn 70 1/2. These required withdrawals are also known as required minimum distributions (RMDs).
  • Traditional IRAs can be either “deductible” or “non-deductible”.
    • The key difference is that, with a “deductible” IRA, you get a current year tax benefit effectively making it a pre-tax contribution. For example, if you are in the 25 percent tax bracket and you contribute $5,500 to an IRA, you will save $1,375 on your tax bill. In other words, you are effectively only contributing $4,125 to fund your $5,500 IRA.
    • For a “non-deductible” IRA, you make contributions with after-tax dollars, so your contributions are your cost-basis. When you make withdrawals, only the gains are taxed as income.

A Roth IRA is a retirement vehicle that allows your account to grow tax-free, as opposed to tax-deferred. That is, you pay no taxes for any withdrawals (after age 59 1/2) irrespective of the interest and gains you have made on your initial contributions.

  • “Is It Better to Contribute to a Roth or Traditional IRA?,” NerdWallet.com . This article compares a Roth IRA to a traditional deductible IRA, where you receive a current year tax deduction. There are arguments for both. Conventional wisdom says the Roth is better if you are younger, while the traditional may be better if you are closer to retirement age.
  • Our blog post is focused on a converting a non-deductible IRA into a Roth IRA. You get no current year deduction with a non-deductible IRA, so if you can convert to a Roth without any tax consequence, then the Roth conversion option is superior.

IRA Income Limits:

Roth Conversion changes tax status of an account from a traditional IRA to Roth IRA.

 

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