As we approach the end of what's been nothing short of an interesting year, many high-earning individuals and couples are now taking the time to reevaluate their retirement strategies. Given the imposed income limits to make direct Roth IRA contributions, creative savers often consider the backdoor Roth IRA, which involves contributing money to a traditional or non-deductible IRA first, and then converting the contribution to a Roth IRA (thus incurring no income tax). Before doing this -- a tactic that we'll delve into below -- it's absolutely imperative that you evaluate your entire IRA picture from a bird's-eye view to avoid a self-inflicted and unnecessary tax bill.
What is a backdoor Roth IRA contribution?
As many retirement savers are aware, there are income limits associated with contributing to a Roth IRA in any given year. Since these limits will primarily apply to individuals earning over $139,000 and married couples earning over $206,000, this is a good problem to have. The desire to move money to the Roth, a never-pay-tax-again vehicle, is still worth satisfying as the significance of tax-free growth in a retirement plan cannot be understated.
A successful backdoor Roth IRA contribution has three steps. First, you will deposit money (a maximum of $6,000 in 2020 and 2021) to a traditional or non-deductible IRA. If you don't have one, you can open one in less than five minutes at any of the major discount brokerages: Vanguard, Fidelity, Interactive Brokers, and the like. Once the money has been deposited to the traditional or non-deductible IRA, you can simply leave it in cash without taking the further step of investing it.
Next, a few days later, you'll want to convert the money you just deposited to a Roth IRA. There should be an option on your account dashboard that says "Convert to Roth" or something similar -- there isn't any need for unnecessary paperwork or phone calls here. When you select the option to convert, you're agreeing to move money from an account that typically contains pre-tax money (but not always) to an account that solely contains after-tax money. Because your contribution in the first step has already been taxed, there is no additional tax assessment upon conversion to the Roth.
The third step, which may seem obvious but can be overlooked, is to invest the money once it's arrived in your Roth account. Your choices are endless, but generally your Roth account is a great place for a pure stock ETF or mutual fund. Roth IRAs, since they contain money that won't be taxed again, are an ideal home for high-growth investments that you don't expect to sell in the near future.
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What you need to do first
Before trying this, assuming you are in fact over the income limits for a direct Roth IRA contribution, you'll need to evaluate your entire IRA picture. If you have any preexisting, pre-tax IRAs, including other traditional IRAs, rollover IRAs, SEP or SIMPLE IRAs, you will need to thoroughly consider your options before attempting a backdoor Roth contribution.
The reason for this is the famed "pro-rata rule." If you have other pre-tax IRAs, when you try to convert your newly opened traditional IRA to a Roth account, the IRS will consider the conversion as having come from your entire IRA balance as of Dec. 31 of the tax year. That is, your conversion will be taxed on a "pro-rata" basis, relative to the other pre-tax IRA accounts you hold.
For example, say you have $100,000 of pre-tax money in a SEP IRA. In an attempt to complete a successful backdoor Roth IRA contribution, you contribute $6,000 to a traditional IRA. Upon conversion of the $6,000 to Roth, the IRS will see this as a taxable event. Your entire IRA balance is $106,000, and $100,000 (or 94.34%) of your balance has not yet been taxed. When you convert $6,000 to Roth, in this example, 94.34%, or $5,660, will be considered taxable income to you. In the 24% bracket, this will increase your federal tax due by $1,358.
A cure to the potential pitfall
There are many solutions here, but the most practical solution is to see if you can first roll your existing pre-tax IRAs into your employer plan (a 401(k) or 403(b)) before trying the backdoor Roth IRA. This will allow you to eliminate your other IRAs and therefore eliminate the potential for undue or unexpected taxation. If you are self-employed and don't have access to an employer plan, you might consider opening a solo 401(k) to receive potential IRA rollovers.
The backdoor Roth IRA is a great tool available to high income earners, but it's of great importance to view the conversion in the context of your total financial picture. This is a useful exercise even if you don't end up employing the backdoor Roth strategy, and will allow you to plan for conversions several years into the future.
