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.