The backdoor Roth IRA is an excellent conversion strategy that gives you the opportunity to contribute to a Roth even if your income is over the modified adjusted gross income phase-out ($129,000- $144,000, single or $204,000- $214,000, married filing jointly for 2022). The best part? The conversion may be completely or at least partially tax-free.
How do you go about contributing to a Roth through the backdoor?
- Open a Traditional IRA and make a non-deductible contribution. I recommend a seperate IRA for non-deductible contributions.
- Open a Roth IRA
- Convert the non-deductible contribution in the Traditional to the Roth
- Continue every year until it doesn’t make financial sense, your earned income decreases below the phase-out level, or the loophole is closed.
Backdoor Roth IRA = Tax-free conversion goodness
A great cup of coffee, my Grandmom’s crumb cake, and tax-free conversions. Three of my favorite things. Yes, the backdoor Roth IRA could be 100% tax-free, if non-deductible contributions.
The ifs, ands, or buts of tax-free
It’s retirement savings and taxes; there are always ifs, ands, or buts. So don’t go out and try the Backdoor Roth IRA just yet. There are other considerations when determining the level of tax-free goodness.
- Do you already have any Traditional (including a Rollover IRA), SEP, or SIMPLE IRA’s?
- Are those IRAs funded with deductible/before-tax contributions?
If the answers are yes, then some calculating is needed to determine how much tax-free fun you can have.
Backdoor Roth IRA Examples
#1 No other IRA’s
If you have no other Traditional, SEP, or SIMPLE IRA’s and just made a non-deductible contribution of $6,000 to your new Traditional IRA. Congratulations, the entire $6,000 will be tax-free when you convert it to the Roth. That’s easy and when the Backdoor Roth IRA gets the biggest bang.
#2 Other IRA’s
You have the following:
- Traditional IRA $20,000, funded with deductible contributions
- SEP IRA $24,500, funded with deductible contributions
- New Traditional IRA with $5,500, funded with non-deductible contributions
Here are the steps to figure out the tax-free amount:
- Add up the all IRA’s $20,000 + $24,500 + $5,500= $50,000
- Divide the non-deductible contribution by the total IRA amount: $5,500/$50,000 = 11% (.11)
- Multiply $5,500 x 11% = $605 is the non-taxable conversion amount
- $4,895 is the taxable conversion amount
Clearly not as beneficial as the first example, that doesn’t necessarily mean it’s a deal-breaker. This obviously is more of a typical Roth conversion, and we need to dig deeper to find out how appropriate and beneficial this is for you. Which leads me to…
How often do I recommend the Backdoor Roth IRA?
I’ve been recommending the Backdoor Roth IRA strategy since 2010 when the $100,000 MAGI limit for Roth conversions was eliminated. But, I don’t recommend it for every client that is above the threshold. Other factors such as your age, current tax rate, future expected tax rate, other IRA balances, and cash available to pay taxes on the conversion if there are any (example 2) enter into the equation of appropriateness.
Mix and match
What if you have a mix of deductible and non-deductible contributions in the other IRA’s? In this case, do not include the non-deductible IRA amounts when adding the up the IRA’s. In example #2, if that SEP IRA had $10,000 of non-deductible contributions, step 1 would be $20,000 + $14,500 + $5,500= $40,000.
Desperate for tax-free
There is a way to avoid including all of your other IRA’s. If you can roll your other IRA’s into your company retirement plan or solo 401(k) that would take them out of the equation and increase the tax-free conversion amount. I have rolled IRA’s into a solo 401(k) to increase the benefits of the Backdoor Roth IRA. Whether you want to roll it into your 401(k) or 403(b) depends on if they permit rollovers into the plan, if the plan has a robust selection of funds available, and if the fees of the plan are reasonable.
Don’t do it
What happens if you got a hot stock tip from your brother-in-law and invested that $6,000 non-deductible contribution and it grew to $10,000 before you implemented the backdoor Roth IRA? You’ll end up paying tax on the growth. Do what I do, don’t listen to your brother-in-law, when did his stock tip ever pay off. Wait, sorry, I meant to say that within days of the non-deductible contribution, move that baby over to the Roth.
The backdoor Roth IRA is not something you should try at home. It’s a great strategy to get you into a Roth when otherwise you would be unable to. So before you do anything, give me a call, and we can analyze whether it’s appropriate and if it is, we can take the correct steps to avoid any tax surprises.