A tested, fully legitimate strategy for those who don’t usually qualify for a Roth IRA to enjoy its benefits. As much as $150k of value for employing one tax optimization strategy early in your career.
After this Tuesday’s post, Four One Percenter Couples Share How They Do Money, I received several emails from readers asking about the backdoor Roth IRA that a few of the couples employed. This was an excellent reminder to me to walk through the strategy, as it is one I employed while working, and I believe could have a very useful place in your arsenal.
A Quick Refresher on IRAs
If you have taxable compensation in any given year, you qualify to invest in an Individual Retirement Account (IRA). There are two options for IRAs, and they offer different kinds of tax advantages.
Traditional IRA – If you make below a certain amount annually, your contributions to the IRA are tax-deductible. The money is also allowed to grow tax-free until you begin withdrawing your funds in retirement. At that point, your withdrawals are taxable at your then-ordinary income tax rate.
There is no income maximum for being eligible to contribute to a traditional IRA, but there is an income maximum after which you become ineligible to deduct your initial contribution on your tax return. You still would get the ability to grow the money tax-free, but your contributions are not tax-deductible.
Here are the income brackets at which the tax-deductible contribution benefit phases out:
|Traditional IRA Income Restrictions (MAGI) – 2017|
|Full Deduction||Deduction Reduced||Completely Ineligible|
|Single||Less than $62,000||$62,000||$72,000|
|Married||Less than $99,000||$99,000||$119,000|
|Note: The eligibility brackets are actually a little more complicated for traditional IRAs depending on whether you or your spouse are covered by a workplace retirement plan or file separately. The chart above shows only the most conservative brackets (assumes the lowest cap). For a more detailed chart, click here. For simplicity, I will use only the figures in this summary chart for purposes of this article.|
Roth IRA – If you make below a certain amount annually, you are eligible to open a Roth IRA. You must pay taxes on your initial contributions to the Roth IRA, but the Roth makes up for this in other ways: not only will your money grow tax-free until retirement as a traditional IRA would, but you will also be able to make all your withdrawals in retirement completely tax-free.
Unlike the traditional IRA, there is a hard income cap on who is eligible to open a Roth IRA. As of 2017, these are the income restrictions:
|Roth IRA Income Restrictions (MAGI)|
|Full Contribution Eligible||Contribution Amount Reduced||Completely Ineligible|
|Single||Less than $118,000||$118,000||$133,000|
|Married||Less than $186,000||$186,000||$196,000|
Who Should Consider The Backdoor Roth IRA?
The backdoor Roth IRA is not necessary or particularly advantageous for everyone.
For those who qualify for the full tax advantages of both the Traditional IRA and a Roth IRA, the decision of which to choose depends primarily on whether you think your tax rate will be higher or lower in retirement than the tax rate you pay now. If you think you’re paying lower taxes than you will in retirement (often the case for those early in their careers and still building their earning potential), you would opt for the Roth. For those who are in high brackets already and who think their income will put them in lower brackets in retirement, you may do better taking advantage of the tax-deductible contributions up front and thus having ‘more money working for you for all these years.’ Since they qualify for both products, these folks have no need for a backdoor Roth.
For an individual who makes between $72k-$133k or a married couple who makes between $119k-$196k*, your best bet is to contribute to a Roth IRA directly. You don’t qualify for tax-deductions on your contributions to a Traditional IRA, so why not invest the same exact dollars in a Roth IRA instead and get the same benefit of a Traditional IRA of growing your money tax-free, but also the additional benefit of tax-free withdrawals that a Traditional IRA doesn’t offer? Since you are eligible to open a Roth IRA directly, you don’t need to employ the backdoor Roth IRA strategy to get its benefits.
There’s another group, however, who aren’t allowed to enjoy all of these benefits. If you are an individual who makes more than $133k or a married couple who makes more than $196k per year, your options are limited. You are not eligible for a Roth IRA. You can still contribute to a Traditional IRA, but your contributions are not tax-deductible. What’s your best move?
For this group – individuals who make $133k or more and married couples who make $196k or more – the best move is to employ a backdoor Roth IRA. With a backdoor Roth IRA, you will be able to grow your money tax-free until retirement but also enjoy tax-free withdrawals during retirement, a benefit you did not have access to before.
Quantifying The Benefit
Say you withdraw $50k a year from your IRA in retirement. Had you been in the group we described above and chosen not to use the backdoor Roth – opting for the Traditional IRA instead – you would pay ordinary income taxes of approximately $5.5k a year. With the Roth’s treatment, you would get that $5.5k back in your pocket… every year of your retirement.
Over a 20-year retirement and assuming compound growth of 5% (the money you didn’t have to pay in taxes can stay in the account and work for you), this one strategy could put nearly $182k back in your pocket over 20 years.
How The Backdoor Roth IRA Works
While the IRS restricts who can open and contribute to a Roth IRA by income, there is no restriction on rolling a traditional IRA over into a Roth IRA. Anyone can do this – at any time, with any income.
When you rollover (i.e. convert) a traditional IRA into a Roth IRA, you pay taxes on all the gains thus far made in the account. Then, the remaining funds are allowed to enjoy the full advantages of a Roth IRA – the money grows tax-free until retirement, and it is withdrawn during retirement with no taxes as well. The backdoor Roth IRA strategy takes advantage of this. It has three simple steps:
- Put money in a Traditional IRA account
- Convert it into a Roth IRA – Once the funds post to the traditional IRA, you convert the account into a Roth IRA. All major brokerages easily allow you to do this with a form or sometimes just a few clicks in a walk-through system.
- Enjoy your new tax-optimal system
This is a no-brainer choice for individuals making more than $133k a year and married couples making $196k or more a year. Your best choice was to make nondeductible contributions to a Traditional IRA which can grow tax-free but will be assessed taxes on every withdrawal. With this rollover, you will be contributing the same non-deductible dollars to a Traditional IRA, immediately rolling it over into a Roth IRA, and will now enjoy not just the growth tax-free until retirement but also the added benefit of completely tax-free withdrawals in retirement.
While you must pay taxes on all “gains” in the Traditional IRA prior to the conversion, you just set up the account and there are no gains to speak of, so it is costless to you.
Considerations Before Employing The Backdoor Roth IRA
Taxes are never easy, and it’s important to note a few important considerations before pulling the trigger on a backdoor Roth IRA.
The IRA Aggregation Rule
If you have other existing traditional IRAs, a backdoor Roth IRA may not be for you. The IRS treats all IRAs in your name – whether they are in separate accounts or not – as one aggregate amount. If you fund a new traditional IRA with a $5.5k contribution for the 2017 year, but you have other IRAs under your name (say a rollover of your 401k with an old employer), your contribution is considered on a pro-rata basis across all your IRA assets, not specifically the $5.5k you just dumped into a new account.
Note that 401k’s do not confound the backdoor Roth IRA strategy as long as they are still in a 401k and not converted into an IRA. Your spouse’s accounts in their name have no effect on you even though you are married. But if you have traditional IRA’s in your name already, you will be hit by this rule.
Step Transaction Doctrine
There is a little-discussed procedure arising from the 1935 case of Gregory v. Helgering which establishes that the tax authorities may look at separate steps in a transaction and, if they see no substantial purpose for them to be separate, can treat them as one single transaction. If the steps to building your backdoor Roth are done in rapid succession, there is a risk that tax authorities deem this one transaction meant to try to get you a Roth IRA you weren’t eligible for, and they may disallow you from Roth treatment and unwind the transaction.
Each step outlined in the backdoor Roth IRA strategy is itself legitimate, so the crux of the question becomes how long must one wait in order to show that each transaction had a separate purpose. You will find no consensus on this. Some people wait a week. Some say you should wait a year. Many people ignore this potential issue and get done all on the same day.
Step Transaction Doctrine: How Large Is The Risk?
In practice, the reporting systems for conversion of Traditional IRAS to Roth IRAs generally do not track when the conversion took place, or from which accounts. Few if any people have reported their conversions being unwound even if they were doing the conversion steps in less than 24 hours total. Whether that’s because the reporting limitations make this impossible or whether the IRS doesn’t really care about the issue is anyone’s guess.
You can do some additional research of your own. The question is really how long you want to wait between the fully legitimate steps to clearly delineate that they are separate transactions. Obviously the longer the time separation between steps, the stronger the case that there were separates purposes to the different transactions.
For those who find themselves ineligible for the tax-deductible treatment of traditional IRAs and are looking to supercharge their retirement plans, the backdoor Roth IRA is an excellent tool that can be worth over $150k of value during your golden years.
Do you employ a backdoor Roth IRA strategy? What tax-advantaged accounts do you use?
*Note: The income brackets for IRA benefit eligibility change over time and are more complex for married couples than summarized in the table in this post depending on whether or not they file jointly, are covered by a workplace retirement plan, and other factors. As you consider your optimal strategy, I encourage you to double check the income brackets which apply to your specific situation and/or consult a tax professional.