Is The Backdoor Roth IRA Contribution Right For You?

This "loophole" is a legitimate way for higher earners to be able to contribute to Roth IRAs every year. But there is one potentially huge possible pitfall to be aware of.

Despite its slightly shady-sounding name, the Backdoor Roth contribution is a perfectly legal and efficient strategy that can be used by higher earners to be able to make Roth IRA contributions that they are otherwise prohibited from making. But care is required.

In this article, I will address:

  • Who needs to make use of a Backdoor Roth contribution?

  • Who does not need to make use of it?

  • What is the process for implementing the strategy and by when does it have to be completed?

  • The one big thing that you need to be VERY aware and careful of before deciding whether or not to implement a Backdoor Roth strategy

If your Modified Adjusted Gross Income (MAGI)*** for the calendar year ending December 31st is going to be above the current IRS income limits which are $139k for a single filer and $206k total of the two MAGIs for those filing jointly (2020), then you are not permitted to make a direct contribution to a Roth IRA for this year. 

For a review and an explanation of all the most recent contribution limits of Roth IRAs as well as Traditional IRAs and workplace retirement plans, see my article “New 401k and IRA Contribution Limits”.

Your tax preparer will be able to tell you what your current year MAGI is once they have all your information.

*** See here for what constitutes MAGI and how it may differ from simply Earned Income.

Note that if you are a single filer whose MAGI is above $124k but below $139k or a married filer whose total joint MAGI is above $196k but below $206k, (2020) you are entitled to a partial, pro-rated direct contribution, but will need to use the Backdoor method for the balance.

So if your MAGI for the current year is less than $124k (single filer) or less than a total between the two of you of $196k (married filer), then you have no need to employ the backdoor contribution strategy and can directly make up to the maximum contribution for this year in one step (2020 maximum is $6k per individual or $7k if aged 50 or over) any time before April next year by simply contributing as normal.

Indeed, you have no need to read this article any further! :-)  

For the rest of you, here is the best-practice process for making a Backdoor Roth IRA contribution:

  1. Before early- to mid-March next year, (do not leave it till the last few days before tax day in April) put the amount you want to contribute by this method into a Traditional IRA, NOT a Roth. If contributing after January 1st, make sure the contribution is tagged as being for the “older” previous year, not for the “newer” current year. If you do not have a Traditional IRA in place then open one for this purpose at the same provider where you hold your Roth, it's easy to do. Because of how much you earn, this will be considered a non-deductible contribution to the Traditional IRA, i.e., you get no tax break this year for this contribution.

  2. Wait at least two or three business days (days that the stock market is open). The reason for this is that the IRS prefers to see this as a two-step process.

  3. Rollover the contributed amount from your Traditional IRA to your Roth IRA at the same provider as a "same trustee transfer". Your investment platform provider support staff or your financial advisor can implement this for you.

  4. Assuming the Traditional IRA was empty before you contributed to it (see below, very important), your only potential tax liability for this transaction is on any short term capital gain that may have occurred during the short while that it sat in the Traditional IRA account before the conversion. 

    Voila! The contribution dollars are now in your Roth IRA and all future qualified withdrawals will be tax and penalty free. 


.. The Pro-Rata Rule. 

The IRS requires that rollovers from Traditional IRAs to Roth IRAs to be done pro-rata. If you have no existing balance in any Traditional IRAs, you do not need to worry about this but if you do already have any money in a Traditional IRA, then please read the following very carefully before deciding upon a Backdoor Roth contribution strategy.  

Here's how it works: When determining any tax bill on a conversion from a Traditional IRA to a Roth IRA, the IRS is going to look at all of your existing Traditional IRA accounts combined as of year-end (note: any 401k/403b/457 balances do not count as an existing balance for this purpose and need not be considered in this equation and nor do any inherited IRAs which cannot be converted to a Roth, it just applies to Traditional IRAs, including regular, rollover, SEP or SIMPLE IRAs). 

If any of your existing Traditional IRAs already have a balance of pre-tax money in place (as would be the case if you had previously made deductible contributions or rolled over a 401k or other workplace plan into a Traditional IRA) prior to the conversion, then that ratio will determine what percentage of the money you convert to a Roth is going to be taxable. You can't just pick and choose to convert only the non-deductible money you just contributed; the IRS won't allow that.

Example 1: You have no existing balance in any Traditional IRAs .. you contribute $6k to your Traditional IRA, wait at least two business days, then convert. Your tax liability is limited to any gains that might have been made in the Traditional IRA during that short waiting period, so likely negligible or maybe even not at all.

Example 2: You already have an existing balance of $94k of pre-tax $$ (from prior deductible contributions or 401k rollovers) in your Traditional IRA. The $6k you add as a non-deductible contribution is immediately commingled with the existing pre-tax $94k, creating a total balance of $100k of which 94% is as-yet-untaxed dollars and only 6% is already-taxed dollars. Whatever amount you then choose to convert to a Roth IRA will therefore be deemed to be 94% untaxed and 6% already-taxed. So if you convert $6k to your Roth, then 94% of that ($5640) will be taxed by having it added to your taxable income for that year and only 6% ($360) will be converted tax-free. The money to pay this tax should come from a source other than the IRA itself. 

This pro-rata rule means that the Backdoor Roth contribution may not a good idea if you have a significant existing balance in any Traditional IRAs and do not want to "bring forward" the tax bill on a portion of whatever amount you convert (bear in mind though, the $ in your Traditional IRA has never been taxed and will be one day anyhow, you are just bringing that day forward for a portion of it if you have existing untaxed balances - this process does not create a tax liability that you wouldn't otherwise have). 

Note also that, if you are prepared to pay the taxes now on a conversion (which you may be inclined to do if, for instance, you believe that future tax rates on your withdrawals may be significantly higher and you have the funds currently available elsewhere to make the tax payments or if you presently are experiencing an "outlier" low income year and therefore are temporarily in a lower tax bracket than usual), you can actually convert as much of the Traditional IRA balance as you want.

You are not restricted to being able to convert just the up to $6k you may have just contributed to the Traditional IRA - but the ratioed percentage of taxable/non taxable will remain the same and apply to whatever amount it is that you convert (e.g., in Example 2 above if you decide to instead convert, say, $20k then that amount will be pulled from the newly-commingled total pool of $100k and $18,800 of it - 94% of the total converted amount - would be added to your taxable income that year and only $1200 of it - 6% of the total converted amount - would be converted tax-free). 

If you do decide to go ahead then contact your financial advisor if you need implementation assistance or you can call the support line of your investment platform and a representative should be willing and able to guide you through the process. It will not take long and most support line representatives and any competent financial advisor should be extremely familiar with the strategy and how to implement it.