You might have heard of a backdoor Roth conversion before, but what exactly is it? In short, a backdoor Roth IRA is a way for those with high incomes to take advantage of a Roth account despite IRS contribution limits.
To start with, you have to have an IRA to convert to a Roth. So, if you don’t meet the qualifications for opening a Roth IRA below, you can only open a traditional IRA.
Who Qualifies to Open a Roth IRA?
Not everyone can take advantage of the Roth IRA. There are income limits to qualify to open a Roth IRA, and they are commonly called Roth IRA income phase-outs.
These income phase-outs vary by tax filing status, with different numbers for each filing status. For example, single filers will have different numbers from those who are married joint filers.
Those income limits can be changed by the IRS on an annual basis. You can check the IRS website or with your financial professional for more details on whether this might apply to your financial situation.
The Backdoor Roth Conversion Process
People who don’t meet the qualifications above are unable to open a Roth IRA and leverage its great advantages for tax-free benefit. However, they can do a backdoor conversion that has no income limits.
Here are the steps to your backdoor Roth conversion. These steps are intended to help as a starting point at a high level. If you do have questions about a backdoor Roth conversion for your personal situation, or for more information in general, speak with experienced financial advisors and tax advisors.
Fund a Traditional IRA
Even if you can’t have a Roth IRA, you can have a traditional IRA. You may, in fact, already have one, or you might need to open one and fund it.
Convert the Traditional IRA to a Roth IRA
Ask your IRA custodian or administrator for instructions and paperwork to convert to a Roth IRA. There are no income limits for making this conversion. You will be opening a Roth IRA account as part of this process. It will hold the funds transferred from your existing traditional IRA.
Handling the Backdoor Roth Conversion for Tax Purposes
Only post-tax dollars can go into Roth IRAs. Since you have likely deducted the money that is now in your traditional IRA, you are going to have to pay income taxes – at your marginal rate – for that money you want to convert to a Roth IRA now.
In effect, you are giving Uncle Sam his deduction back. When you file taxes for the year of the conversion, you will have to report the conversion and pay taxes at ordinary income rates on all the dollars you converted.
Say Hello Again to the Taxman
After you have paid taxes on all the transferred assets, taxes will also be due at the same rate on all your investment gains in your traditional IRA.
If you recently started your traditional IRA to convert it, there probably isn’t much income. But, if it’s an IRA that you have had for years, there is probably a lot of income to pay taxes on.
How to Make the Transfer for the Conversion
You can’t just transfer your traditional IRA any way you want to. To avoid penalties, your conversion must be one of the following types of transfers:
- A rollover, where you personally receive the money from your traditional IRA and then you deposit it into your Roth IRA within 60 days. If you don’t make this deadline, you will pay for a significant premature distribution.
- A trustee-to-trustee transfer is the kind of transfer where the traditional IRA provider/custodian sends the money in your traditional IRA directly to your Roth IRA provider/custodian. Since the money would never be in your hands, there is reduced risk of not getting the money into the new account within 60 days.
- A “same trustee transfer” is one where your money moves from a traditional IRA to the Roth but stays at the same financial institution. It’s by far the easier of these three.
The Pro-Rata Rule
There are many steps to a backdoor Roth conversion. Your financial professional should help you explore all of the pros and cons before moving forward with any sort of decision.
All of that said, there is the pro-rata rule for rollovers to a Roth IRA from a traditional IRA. So, what does this mean?
When you make your conversion, the IRS will expect you to look at all your traditional IRAs combined to find out how much pre-and post-tax dollars are, on average, in the accounts.
As a high income earner, you may have put some money into your traditional IRA that were after-tax, non-deductible contributions. These after-tax contributions will affect how much in income tax will be due on the conversion.
The pro-rata rule is intended to stop someone from cherry-picking accounts for conversion that have mostly after-tax contributions in order to reduce their income taxes on a conversion. This is a way that the IRS guards against this possibility.
The IRS requires that you:
- Add up the balance in all of your traditional IRAs together,
- Find the total amount of after-tax, non-deductible contributions,
- Divide the total after-tax, non-deductible contributions by the total balance and come up with the percentage of the conversion that is tax-free,
- Multiply the converted amount by the tax-free percentage, and
- Subtract the non-taxable portion of the conversion from the total conversion amount to get the taxable conversion portion.
Your tax and financial professionals can help you in calculating these numbers and answering any questions that you may have, including what an example calculation may look like.
Note that this tax calculation on the funds happens at year-end regardless of when you converted the account.
Is a Backdoor Roth Conversion Worth It?
So, with all the taxes and ratios, is a backdoor conversion worth the trouble? To answer that question, consider these thoughts.
– If you can only pay all those taxes with the taxes from your IRA distribution, then you might not gain enough from the conversion to make it worthwhile for you.
If you have to take money out to pay the taxes, that reduces the future growth potential of your account – and by extension, more future retirement income. It might not be worthwhile, especially if you are under 59.5 and will owe early withdrawals penalties as well.
– If you may need the money within five years or less of the conversion, it may not be worth it for you. This applies especially if you are under 59.5 and dealing with a five-year minimum holding period.
Even if you are beyond 59.5, you might be losing out on growth potential for your money should you need it in five years or less. Your financial professional can help you navigate the pros and cons as you explore this for your complete financial situation.
– If you think converting the entire account balance might push you into a lot higher tax bracket, it may not be worthwhile if the future tax savings don’t offset the increased tax bill.
To avoid this, you might consider steps of partial conversions each year to avoid paying a tremendous tax bill. That can help in managing your tax liability.
Some Final Thoughts on a Backdoor Roth Conversion
As you may know, a Roth IRA can give further tax-free growth and tax-free retirement income. You will have paid your taxes and be able to use those funds in retirement without paying income taxes on them.
That being said, a backdoor Roth conversion has many moving parts and involves some technical details. This is one thing that someone doesn’t want to get wrong. Your financial professional should have a clear understanding of different tax strategies and how to execute on them, including this conversion strategy.
They should have experience in developing and following through on tax strategies for other clients of theirs. The penalty for having this be wrong can be steep tax liability, otherwise. It’s also highly recommended that you speak with experienced tax advisors about this option and the upsides as well as downsides for your circumstances.
Don’t be afraid to ask questions and establish a comfort level. After all, these are your retirement funds on the line. You worked hard to accumulate them, and you should be confident that those helping you plan for retirement are well-qualified.
If you are looking for a financial professional to assist you with this and other retirement what-ifs, many independent financial professionals are available at SafeMoney.com to assist you.
You can get started by visiting our “Find a Financial Professional” section to connect with someone directly. Feel free to request an initial appointment to discuss your goals, needs, and situation, and explore a potential working relationship. Should you need a personal referral, please call us at 877.476.9723.