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Backdoor Roth IRA: Avoid this Big Mistake Thumbnail

Backdoor Roth IRA: Avoid this Big Mistake

A Roth IRA (Individual Retirement Account) can be one of the best vehicles to put away money and have that money grow and be withdrawn tax-free.

The problem is as your income grows you are phased out from being able to contribute to a Roth IRA.  

Enter the Backdoor Roth IRA, a way for you to be able to get money into a Roth IRA annually even if you make too much money. 

What is a Backdoor Roth IRA

A Roth Individual Retirement Account (IRA) is a tax deferred account that you contribute after tax dollars to that then grows tax deferred and ultimately you can withdraw later tax-free via a qualified distribution.  

The problem is there are income limits for you to contribute to a Roth IRA.  

Roth IRA Income Limits (2021)

Filing StatusModified Adjusted Gross IncomeContribution 
Married Filing Jointly (MFJ)>$207,999Phased Out
Single or Married Filing Sep (Didn't Live with Spouse for more than 6 months)>139,999Phased Out
Married Filing Separately (Live with Spouse)>9,999Phased Out

Once your income increases over those amounts you are totally phased out from being able to contribute to a Roth IRA.  Enter the backdoor Roth IRA.

Backdoor Roth IRA- 2 Step Process

The Back Door Roth IRA is a 2 step process.

How does a Back Door IRA work?
It essentially a process that allows you to get money into a Roth IRA by by sidestepping a direct contribution but rather doing a conversion from a traditional IRA..  

Step 1: You contribute to a Traditional IRA

There are no income limits to contribute to a traditional IRA.  You can make 1 million dollars a year and still be able to contribute to a traditional IRA.

The amount of income you make determines whether or not the traditional contribution you make is tax deductible or not.  

Generally if you or your spouse earns in excess of the income numbers that causes you to be phased out from contributing a Roth IRA and you have a retirement plan at work, then your Traditional IRA contribution is non-deductible. 

Now that you have opened and contributed to a traditional IRA for this year, you move onto to step 2.

Step 2: You Convert the Traditional IRA to a Roth IRA

There are NO income limits to do a conversion from a traditional IRA to a Roth IRA.

Since the money you contributed into the Traditional IRA is after tax or non-deductible, when you do the conversion there are no taxes due.   The conversion typically occurs with a phone call or signing paperwork depending if you are doing with your financial advisor vs DIYing it though one of the big institutions (Vanguard, Fidelity, TD, etc)

Once those steps are completed you now have the same amount of money in a Roth IRA as you would had you just been able to contribute to one.

BEFORE you go out and start doing this, you need to know that there is a HUGE Caveat.

Biggest Mistake: Backdoor Roth IRA

The one big caveat is---this does NOT work IF you have any other IRA’s that are pre-tax including a Traditional IRA, Rollover IRA, SEP IRA, or SIMPLE IRA’s.

Do you?  If yes then this likely won’t work.  Stay tuned we have a solution.

The IRS only sees 1 IRA.  You may have 10 IRA accounts spread out at TD Ameritrade, Vanguard, Your Financial Advisor, and / or some other institution.   But the IRS only sees one.  What does that mean?  It means they aggregate all of your IRA's into 1 big one rather than multiple smaller ones.  Let's take an example:

Let’s say that you Rolled over a 401(K) last year to a Vanguard IRA account for $194,000.  

You make too much money to contribute to a Roth IRA and have been doing the Backdoor Roth IRA strategy for the last few years.  You never have had any other IRA's so the backdoor Roth IRA strategy has been working seamlessly. 

You do the same thing last year.  You contributed $6,000 to a new TD Ameritrade Traditional IRA and then later did a Roth Conversion.

You get 2 different statements, one from each company.  In your mind you have 2 IRA accounts and you converted the account in which you made the non-deductible contribution.  

The problem is the IRS only saw 1 IRA and it totaled $200,000 that included both your pre-tax rollover IRA and your $6,000 non-deductible contribution.  Here is what it looked like to them.  

IRA AccountsAllocationPercentage
$194,000Pre-Tax IRA97%
$6,000Post-Tax IRA3%
$200,000Total IRA100%

Before year end you called and converted your $6,000 IRA account company and converted it to the Roth IRA as you have always done in the past. But then comes tax time and when you file your taxes you have this additional tax to pay. but don't understand the reason.  Enter the pro-rata rule.

How Does the Pro-Rata Rule Affect my Conversion

The pro-rata rule says you can convert any amount you want, but every dollar you convert will be allocated to a pre-tax amount and a post tax amount to the extent that you IRA has both pre-tax and post tax money in it.  Confused?  Let's take an example:

We had a client that this happened to as they went from being in a group practice to opening their own practice.  They had switched to a new financial advisor and the advisor had them roll over their 401(K) to an IRA.  They had been doing Backdoor Roth IRA for years for her and her spouse.  So they did what they always have done and followed the strategy.  

So here is what actually happens when you do that.

Every dollar that you convert up to $6,000 will be 3% post tax money and 97% pre-tax money.   Based on the allocation of your IRA.  See below.

IRA AccountsAllocationPercentage
$194,000Pre-Tax IRA97%
$6,000Post-Tax IRA3%
$200,000Total IRA100%

$6,000 Conversion
97% of the conversion is Taxable since 97% of your IRA is pre-tax money
3% of the conversion is After-Tax Money since 3% of your total IRA was after tax money.

Of the $6,000 when you do the conversion you are paying taxes on 97% of the $6,000.
$6,000 Converted Amount
97%  Pre-Tax Allocated
$5,820 is taxable income to you.  

We already know you are in a high tax bracket since you are phased out of doing a Roth IRA in the first place.  Let’s say you are in a 35% marginal tax bracket, you will pay $2,037 in taxes to do that conversion that you thought would be 100% tax-free.  

On top of that you also need to track your basis in your remaining IRA accounts going forward and tell the IRS annually what that basis is via form 8606. I have seen people switch CPA’s multiple times and and lose track of their 8606 basis form.  If you do that then you will pay taxes twice on any money that you don’t track and that is after-tax inside the IRA or have to go back and try to re-create those to fix it. 

What is your basis then in this example.  You contributed $6,000 of after-tax money into your IRA and now converted 3% of your after tax portion when you did the conversion.   So you started with $200,000 in traditional IRA's and now have $194,000 in traditional IRA and $6,000 in a Roth IRA.

$194,000 The traditional IRA is now made up of:

Basis Calculation
$6000 Original Non-Deductible IRA Contribution
-$180 Post Tax Portion of the conversion
$5,820 Basis in your IRA Account- Tracked on your 8606 form on the tax return.

Traditional IRA
$5,820 Post Tax Portion of your IRA
$188,180 Pretax Portion of your IRA
$194,000 Total Traditional IRA

The big takeaway here is IF you have any IRA”s including (Traditional, SEP, SIMPLE, Rollover) that has pre-tax money in them then DO NOT do a Backdoor IRA.  It just won’t work the way you want it to.  

Is there a Solution to Fix the Backdoor IRA IF I Have Multiple IRA's?

Yes there are potentially some solutions to fix this going forward.

For the client above there is no way to reverse what was done and she was stuck paying taxes on the conversion via the pro-rata rule for that year.

Going forward though you can either do one of these 2 options.

Option 1: Convert the entire IRA to a Roth---Note: there will be tax consequences here.
This would depend on how much you have in the pre-tax IRA accounts, how old you are and how much income you earn.  

If you have $10,000 in a pre-tax IRA then it may not cost you much to just do a conversion, pay the taxes and then going forward do a Backdoor Roth IRA each year. The reason is if you do it now, it opens you up to being able to do a backdoor Roth annually and if you are 45 that could be another 20 years.

The larger your pre-tax IRA account is the more likely it won't be worth doing this option as the taxes would be too high. Which leads us to option 2.

(One exception may be IF you took a year off or had some large loss that brought your income down to a low tax bracket and you want to convert some pre-tax money to take advantage that year)

We had one client that normally earned $250,000 a year and took a year off and went RVing around the USA with his family.  He earned virtually no income that year, is married with 2 kids so a Roth Conversion that included pre-tax money was worth doing to use up his lower tax brackets.   That sounds like fun way to spend a year, but could I live in an RV?? I'm not so sure. 

Option 2: Roll your Pre-tax IRA’s to your 401(k) at work.  

The problem is your 401(k) plan has to allow for it.   If you own your own business then you control what your plan allows and you can do this strategy.

We are working with a surgeon that is paid as a 1099 contractor and has had a SEP IRA for a number of years.  We made the switch from a SEP IRA to a solo 401(K) for his current retirement plan.  Now he can roll his SEP IRA balance into his 401(K) leaving $0 in pre-tax IRA’s and allowing him to do a backdoor Roth IRA.

Don’t have your own business?  What about a side hustle or side 1099 income (Locums)?  If so you may be able to setup a solo 401(k) and roll the funds into that.

If you are a W-2 employee and have a 401(k) at work, then you can contact your employers 401(K) and see if they allow for roll in’s.  If they do, you can roll the pre-tax money in leaving only your after tax IRA money.

Now you have no pre-tax IRA’s and you can convert the post tax IRA account and / or continue to do the Backdoor Roth IRA strategy. 

If we continue with the example from above. 

Traditional IRA
$5,820 Post Tax Portion of your IRA
$188,180 Pretax Portion of your IRA
$194,000 Total Traditional IRA

She could roll the $188,180 pre-tax IRA to her 401(k) and then continue with the Backdoor Roth IRA strategy annually.

Is a Backdoor IRA worth the effort if I have to roll the funds into a 401(k)?

Having a solid financial team makes all of this much easier.  Don't have one---contact us today at 813-252-0829.

It may not seem worth the effort to do something like this. After all an IRA contribution is only $6,000 per year if you are under 50.  It doesn't seem like much, but once you get the train rolling, it can really gain speed. 

Let’s assume that you and your spouse are 45 years old, you are planning on working in some form until you are 65.  That gives you 20 years to potentially do a backdoor Roth IRA.

20 Years
8% (Assumed Rate of Return)
$12,000 5 years (under age 50) - you do a backdoor Roth IRA for you and your spouse at $6,000 each
$14,000 15 Years (15 and Older)- you each increase it at age 50 for the additional $1,000 catch-up contribution

$646,691 Total Roth IRA (323,345 Each)

That's a significant enough amount that would allow you to blend your tax-free money with your taxable money to manage your future retirement taxes.  

Backdoor Roth IRA's are well worth it, you just need to make sure that you avoid the big trap that many people accidentally fall into by not knowing all of the rules.  If you do you got your tax-free retirement bucket started.  

Need help with this strategy and other strategies like this?  You can also call or text us today at 813-252-0829 or just simply BOOK A TIME on our calendar.