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 2023 is going to be above the 2023 IRS income limits which are $153k for a single filer and $228k total of the two MAGIs for those filing jointly, then you are not permitted to make a direct contribution to a Roth IRA for that 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 newly-updated article “New 401k and IRA Contribution Limits for 2023”.
Your tax preparer will be able to tell you what your current year MAGI is once they have all your information.
Note that if you are a single filer whose MAGI in 2023 is above $138k but below $153k or a married filer whose total joint MAGI is above $218k but below $228k 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 2023 is less than $138k (single filer) or less than a total between the two of you of $218k (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 (2023 maximum is $6,500 per individual or $7,500 if aged 50 or over) any time before April 2024 by simply contributing as normal.
In fact, you have no need to read this article any further. Enjoy the rest of your day! 🙂
For the rest of you, here is the best-practice process for making a Backdoor Roth IRA contribution:
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 usually very 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.
Wait at least two or three business days (days that the stock market is open), just to be sure. The reason for this is that the IRS still prefers to see this as a two-step process.
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 help implement this for you.
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 period of time 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.
BUT THERE IS A VERY BIG “HOWEVER” !! ..
Welcome To 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 implementing 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 specific piece of 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 $6,500 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 $93,500 of pre-tax $$ (from prior deductible contributions and/or maybe 401k rollovers) in your Traditional IRA. The $6,500 that you add as a non-deductible contribution is immediately commingled with the existing pre-tax $93,500, creating a total balance of $100k of which 93.5% is as-yet-untaxed dollars and only 6.5% is already-taxed dollars. Whatever amount you then choose to convert to a Roth IRA will therefore be deemed to be 93.5% untaxed and 6.5% already-taxed. So if you then convert $6,500 to your Roth, then 93.5% of that ($6,078) will be taxed by having it added to your taxable income for that year and only 6.5% ($422) 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 convert the entire and “bring forward” the tax bill on the untaxed 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 – so 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 are presently 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 $6500 you may have just contributed to the Traditional IRA – but the ratio-ed 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 $18,700 of it – 93.5% of the total converted amount – would be added to your taxable income that year and only $1,300 of it – 6.5% of the total converted amount – would be converted tax-free).
But the result will be that the converted funds are now in your Roth IRA instead of your Traditional IRA and therefore will never be taxed again.
For Anglia Advisors clients, I am happy to offer assistance in coming to a decision on and/or implementing this strategy.
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The material contained herein is informational only and at no time ever intended to constitute tax, legal or medical advice. It is also wholly insufficient to be exclusively relied upon as research or investment advice or as a sole basis for any investment decisions. The user assumes the entire risk of any actions taken based on the information provided in this or any other Anglia Advisors post.