I am a big fan of Roth IRAs, and I think just about everybody should have one. The best part? As long as you have earned income, you can!
I tackled the topic of contributing to a backdoor Roth IRA if you are over the income limit for regular contributions in my last post. But I had one caveat — backdoor Roth IRA conversions should be done when the only traditional IRA money you have is that after-tax (nondeductible) contribution you made with the intention of doing a Roth conversion and you have no other pre-tax money in any traditional IRAs. If it happens to be the case that you do, there are ways to fix that.
Why do I have money in a pre-tax traditional IRA?
Since you’re looking to do a backdoor Roth, and the income limits for Roth contributions are higher than the income limits for pre-tax traditional IRA contributions, you probably haven’t recently been contributing to a traditional IRA. But maybe a few years ago, you were earning less and you did make contributions. Or maybe you did because you didn’t have a 401(k), so you used a traditional IRA.
Another common source of pre-tax IRAs are 401(k) rollovers. When you leave a company, you’re allowed to move your 401k to either another 401(k), or roll it over to an IRA.
In the past, this was usually the best choice — an IRA has the advantage that you pick the brokerage, so you can go somewhere with the best (i.e. lowest cost) fund choices. But these days, employees are demanding better 401ks and many companies are delivering. That fact combined with the desire to do a backdoor Roth leads to me frequently recommending clients avoid rolling over their 401(k)s to IRAs.
What’s the problem with having a pre-tax traditional IRA?
It all comes down to taxes. Money that goes into a Roth IRA, via direct contribution or conversion, must have already been subjected to income taxes. If you are converting a pre-tax traditional IRA with $5k in it to a Roth IRA, you will add that $5k to your taxable income for the year. However, if you put $5k in an after-tax IRA, you have already paid taxes on that money and so no further taxes are incurred when you convert to a Roth IRA.
But what if you have post pre-tax and after-tax dollars in traditional IRAs? Even if they’re held in separate accounts, you can’t cherry-pick the after-tax dollars for conversion. You have to convert a prorated amount of pre-tax and after-tax dollars based on the ratio you hold, and then have to pay taxes on any pre-tax dollars converted. So, if you contribute $5500 to an after-tax IRA but already have $55k sitting in a rollover IRA, then over 90% of any amount you convert to Roth will be taxed. That’s not what we want!
So am I out of luck, or is there some way I can still do a backdoor Roth IRA?
Fear not. We didn’t come this far just to be disappointed. The prorata rule only applies to money in your IRAs, so the solution lies in getting your pre-tax funds out of your IRA.
The best option for clearing out your pre-tax traditional IRA is if you employer will allow you to roll-in your IRA to your 401(k). This is pretty common. And when doing a roll-in, you do not do it on a prorated basis. In fact, only pre-tax money may be rolled into a 401(k).
If you don’t have a 401(k), or yours doesn’t allow roll-ins, another option is to open a solo 401(k) with a brokerage that does. In order to open a solo 401(k), you’re going to need to have some self-employment income.
So, now’s the time to break out that entrepreneurial streak and find someone to pay you to do something, anything. You’ll report it as taxable income, use that income to open a solo 401(k), and the roll-in your pre-tax traditional IRA to clear the way to allow backdoor Roth contributions for years to come.
When do I need to clear out my pre-tax IRA by?
Most things with the IRS are evaluated on an annual basis, and this is no exception. All that matters for getting your backdoor Roth conversion done with no additional taxes is that your pre-tax IRA be rolled into a qualifying account before December 31st.
This seems like a lot of work just to be able to do a backdoor Roth IRA.
If you can roll your your pre-tax IRA into your employer’s 401(k), you are looking at about 30 minutes of work. I’ll refer you back to my initial post on backdoor Roths — 30 years of backdoor contributions will likely yield a tax-free gain of $219k (in 2017 dollars) on your $165k investment. Double that as a married couple and then scale all those numbers up for inflation, and you’re looking at a huge present for which your 70-year-old self will thank you.
Whenever I talk to a high-earner who wants to know what their financial priorities should be my response is always the same — max out your 401(k) to the full IRS limit ($18k in 2017) and max your Roth IRA.
With surprising frequency, I am met with the protest, “I make too much money to contribute to a Roth IRA.” Some people are aware of the fact there is an income limit on making Roth IRA contributions, with phase-outs starting at $118k MAGI for singles and $186k for married couples as of 2017. But fewer seem to be aware of the fact that in 2010 Congress changed the rules so that taxpayers at any income level can contribute by doing a so-called “backdoor Roth conversion.”
Lest you fear the term “backdoor” imply something nefarious, I assure you it doesn’t. Those congress-critters that voted on this change had plenty of self-interest motivating them. In fact, most of them take advantage of this provision, and so should you! While rumors pop up now and then that this provision may be altered in the future, such changes would not be retroactive, and should not be a deterrent to maximizing your tax-advantaged holdings today.
To illustrate the value of Roth contributions, here’s an example, with all numbers in 2017 dollars using a real rate of return of 5% — if you put the IRS max of $5,500/year into a Roth IRA for 30 years you would end up with $384k from your $165k of contributions, a gain of $219k from which you can withdraw completely tax-free in retirement! (Or you can allow it to continue to grow - Roth IRAs make a great inheritance vehicle.) And even before age 59 ½, the amount of your principal contributions can be access tax and penalty-free at any time, so you don’t sacrifice liquidity as you start to save.
So what is this backdoor Roth thing?
As of the law change in 2010, while there is still an income limit on Roth IRA contributions, there is no income limit on conversions from a traditional IRA to a Roth IRA. Furthermore, there is an income limit on taking a tax deduction for contributing to a traditional IRA, there is no limit on making an after-tax (nondeductible) traditional IRA contribution.
Are there any “gotchas” I need to look out for?
There is one big caveat here. Doing a backdoor Roth IRA works best when you have no existing traditional IRAs. If you do, for example because you rolled an old 401k into an IRA, there are options that we’ll discuss in my next post on the Prorata Rule for Roth Conversions.
How exactly do I make a backdoor Roth IRA contribution?
Here’s how it works:
The Finance Buff has a fantastic walkthrough of how to report all of this in online tax software.
How long should I wait between making the contribution and doing the conversion?
Back when the backdoor Roth was new, there were concerns that not waiting long enough between the contribution and conversion steps might be objectionable to the IRS. While it is always possible they could decide this at some point in the future, over seven years and millions of Roth conversions they have not disallowed any for this reason. Go ahead and do your Roth conversion whenever is convenient after the traditional IRA deposit has cleared.
Is there a five-year rule on withdrawing principal from a backdoor Roth IRA since it’s a conversion?
No! If you plumb the depths of IRS Form 5329 you’ll discover that the rules restricting withdrawals of Roth IRA conversions only apply to amounts which were subject to taxes in the conversion process, which is not the case for converting a nondeductible traditional IRA.
I thought I was only supposed to contribute to a Roth IRA if I expect to be in a higher tax bracket in retirement.
When you hear that you should “contribute to a Roth if you expect to be in a higher tax bracket in retirement,” that is referencing the choice of making Roth contribution versus contributing to a traditional tax-deferred account. If you’re worried about a backdoor Roth IRA, I’m willing to bet you have an employer-sponsored retirement account and are over the income limit to deduct traditional IRA contributions.
If you are at the point where all your other tax-advantaged account are full, the calculus changes. Now your options are investing in a Roth account where you’ll never pay taxes on this money or it’s growth again, or investing it in a taxable account where every dividend or sale is going to siphon off bits of your money to taxes, eroding your return.
This sounds great! Is there any reason I shouldn’t do this?
With the dual benefits of tax-free growth and the flexibility of withdrawals offered by Roth IRAs, this is a no-brainer for most people. If you have high-interest debt, that should always be your first financial priority. But if you’ve for your bases covered and are looking at how to make the most of your savings for the future, get yourself a Roth IRA.
Maybe you’re leaving your first job and have a few thousand dollars in a 401(k) and have just received a letter asking what you want to do with it. Or maybe you weren’t even given a choice — it is common for small 401(k) balances to be automatically cashed out after you leave a company. It may be tempting to stick that money in your checking account, but you will end up paying a 10% penalty on top income taxes at the end of the year if you do that.
That seed could make a great start to your retirement investing, if you know how to plant it. If you receive a disbursement check, you can deposit it into an IRA within 60 days and it won’t be considered a withdrawal or subject to taxes and penalties. But there are some pitfalls to avoid:
To deal with Pitfall #1, if you had $1500 in your 401(k) and are issued a check for $1100, you can make up the $400 out of your own bank account when making the IRA deposit. The extra $400 will be refunded to you when you file your tax return.
Or, if your 401(k) balance is not sufficient to open an IRA in the first place, you can take this as an opportunity to set aside a bit more money for retirement and top up the rollover to the amount necessary to open a new account.
Assuming you are rolling over from a traditional 401(k), you will initially be putting this money into a traditional IRA. However, if you are a young person in a low tax bracket, or even a student working only part of the year, this can also be a good opportunity to convert that IRA to a Roth IRA. This will cause whatever amount you convert to be added to your taxable income for the year. But if you only made $5k, you will still be below the threshold where you incur any taxes. Even if you are in the 10% or 15% tax bracket, this can still be a great chance to jumpstart your tax diversification for your retirement savings.
Remember, you don’t have to do this alone. Working with a fee-only financial planner can be the perfect way to educate yourself about your options, roll over accounts correctly to avoid penalties, and more. Feel free to contact me today, and we can discuss your unique situation.