Before you get up to your elbows in this article, make sure you understand Traditional Vs. Roth accounts with this course. Backdoor Roth Conversions are a creative way of getting around income limits for contributing to a Roth IRA if you can meet the requirements for it to work.
Roth IRAs have income limits for those who can contribute so high earners, who are often those who benefit more from Roth IRAs, are intentionally left out. That’s where the Backdoor Roth Conversion comes in.
The other component you need to be aware of is that even if you make too much to make a TRADITIONAL IRA contribution (as opposed to a Roth IRA), you can still make contributions without getting a tax deduction. This may seem odd in normal circumstances but it makes perfect sense when planning to execute this strategy.
How does it work?
You need to have both a Traditional IRA and a Roth IRA, ideally at the same institution. This will allow for easier logistics and recordkeeping while going through this process. It is critical to keep good records of all this information. Keep statements and summaries for any year you complete a Backdoor Roth Conversion.
Step 1 – Confirm you don’t have any money in Traditional IRAs (we’ll cover this later)
Step 2 – Open Traditional and Roth IRAs if you don’t already have them
Step 3 – Contribute to the Traditional IRA and let your advisors (CFP, CPA) know that you’ve made a non-deductible contribution. They’ll need to know when covering your tax situation. DO NOT INVEST THE CASH!
Step 4 – A day or two after Step 3, move the cash from your Traditional IRA into your Roth IRA.
Step 5 – Invest Cash
Step 6 – Download copy of statement in time period this occurred and store in your records.
Pro Rata Rule
This rule can be confusing but clears up why you cannot have an Traditional IRA money anywhere if you are going to complete the Backdoor Roth Conversion.
Luckily, each person in a couple is treated as a separate person for this strategy so you can still do it if your spouse has a Traditional IRA.
The Pro Rata Rule refers to the proportional accounting when completing the transfer from your Traditional IRA to the Roth IRA in the process described above. The IRS doesn’t let you cherry-pick specific dollars when completing a rollover, but rather require you to make a proportional conversion. This is best explained with an illustration.
Consider you have $45K dollars of pre-tax money (maybe an old 401K rollover) in a Traditional IRA and you want to complete a Backdoor Roth Conversion. You put $5K into the Traditional IRA but don’t take a deduction which brings the total to $50K. $45K of the money has never had taxes paid on it and $5K has had taxes paid on it.
The Pro Rata Rule prohibits you from stating you want the $5K being moved over and therefore avoiding any tax implications. This rule requires you to prorate the amount in each tax bucket. In this case, it would be 90% taxable (45/50) and 10% tax-free (5/50). 90% of the $5K you converted is now subject to taxes. This means you’ll have 90% X $5K= $4,500 of additional taxable income. That would be taxed at your tax rate, it isn’t the amount of tax you would owe.
Conversely, you wouldn’t owe any tax if you had $0 in an IRA before the $5K contribution because the proportion of the account would be 100% tax-free dollars.
There is an option to avoid this conundrum if you already have money in your IRA. Most 401K plans allow you to transfer IRA money into the 401K. There are some pros and cons to this so talk to a financial professional before completing this complex strategy.
Why should I do Backdoor Roth Conversions?
Backdoor Roth Conversions are generally a good strategy for high-earning people as a supplemental strategy instead of a primary one. People who make too much money to contribute to a Roth IRA normally should generally be focused on tax-minimizing strategies like maxing out 401Ks and HSAs before Backdoor Roth Conversions.
Backdoor Roth Conversions allow for tax-free growth on dollars that would have been saved either way. This strategy can save thousands of dollars in taxes if executed early in one’s career.
As always, talk to a professional if considering executing this strategy as doing something incorrectly could cause it all to be voided and incur taxes and penalties.