The Navigoe Blog

The Backdoor Roth IRA: the opportunity and the caveats

The Roth IRA. It’s a good deal, right? Tax-free growth, no forced distributions at age 70½ and inheritors don’t have to pay income tax on distributions. So, why wouldn’t you contribute to a Roth IRA? Well, there are a couple of requirements and limits. For 2014, the maximum you can contribute is $5,500 ($6,500 if you’re 50 or older). But you can’t contribute more than your earned income. So, if you don’t have earned income, you’re out of luck. On the other end of the spectrum, you are not allowed to make a Roth IRA contribution if you make too much money. How much is too much? In 2014, a married couple can make up to $181,000 and make the maximum contribution (partial contributions are allowed for income up to $191,000. For single folks, the income limit is $114,000 (and partials up to $129,000).

Good news, high income earners, there’s still a way you might be able to make a contribution to a Roth IRA. It’s through a method that is known as the “backdoor Roth IRA” and will require a bit more paperwork gymnastics (and other considerations) than a standard contribution. Here’s how it works.

First step: Open a traditional IRA and make your maximum contribution. This will be a non-deductible IRA contribution (unless neither you or your spouse have a retirement plan at work. But to keep things simple, let’s assume that at least one of you do). Note: there is no income limit on making a non-deductible IRA contribution.

Second step: Convert your contribution to a Roth IRA. Prior to 2010, Roth conversions were not allowed if you made more than $100,000. As of today, there are no income limits to Roth conversions.

What about taxes?
The two step process described above should not cause taxable income. However, there are a few caveats.

Gains in the IRA

Let’s say you make a $5,500 non-deductible IRA contribution for 2013 on April 1st (no fooling). You invest the funds in some sound, low cost mutual funds and wait until July to convert the funds to a Roth IRA. By that time, the market has gone gangbusters, and your $5,500 is now $7,500. Your $5,500 is after-tax dollars and not taxable, but the $2,000 gain is taxable income. So, why would you wait? Keep reading…

The Step Transaction doctrine

The step transaction doctrine is an IRS rule that looks at a series of multiple steps to determine that they were really a single, integrated event. In other words, the non-deductible IRA contribution was merely a step in the process of making a Roth IRA contribution. And since your income is above the limit to make a Roth IRA contribution, it’s not allowed. Without getting too deep in the weeds here, suffice it to say some of the experts in our field on this stuff believe that there is not a case to be made that this is a step transaction. However, to guard against that possibility, the best advice is to wait for a period of time before completing the Roth conversion. How long? There’s no hard and fast rule on this. Some say a couple of days, others a couple of months.

The Pro Rata Rule

This is a big potential “gotcha.” If you have IRA assets other than the non-deductible contribution that you made in step one, you have to consider all of the IRA assets when you calculate any taxes due. This means that when you complete the conversion in step two, you don’t get to decide which assets you are converting. Instead you are converting a proportionate share of ALL of your IRA assets. As an example, if you have a $50,000 pre-tax IRA (from a 401(k) rollover, for example), and you make your $5,500 non-deductible IRA contribution per step one, you now have $55,500. If you convert only the $5,500, then only 9.9% of the conversion is non-taxable ($5,500/$55,500=9.9%).

If you have a big fat IRA and want to do a backdoor IRA, there are a couple of options that might work for you. The first one is to see if your IRA can be rolled over into an employer sponsored retirement plan, like a 401(k), which are not subject to the pro-rata rule. Of course, if you incur greater expenses or investment limitations by rolling over to an employer plan, you should consider whether it is worth it for the backdoor IRA. The other consideration is if you have a big fat IRA, but your spouse does not. The “I” in IRA is for Individual. Even if you and your spouse file your taxes as “married, filing joint”, the pro-rata rule applies to you separately. Despite your IRA, your spouse can still do the backdoor IRA (or vice versa).  Note that a spouse does not have to have earned income to be able to make an IRA contribution.  The income for a married couple is joint, even though the “I” in IRA is for Individual.

Is this worth the effort?

Back when I worked at Charles Schwab as an “Investment Specialist” between 2000-2002, I remember hearing that Charles Schwab (the man, not the company) used to make a non-deductible IRA contribution every year. Back then, the $100,000 income limit prevented him from converting that balance to a Roth IRA, but I am guessing he would have done so (I’m also guessing he made more than $100,000). Keep in mind that in 2002, Chuck (as he was affectionately known company wide) had a net worth of $3.2 billion, placing him at #51 on the Forbes ranking of wealthiest Americans. And the IRA contribution limit at that time was $2,000. Still, apparently he thought it was worth the effort.

For a married couple today, saving an additional $11,000 per year with tax free growth can be a nice addition to a retirement plan. Over 20 years with growth of 8%, this would result in a little over $500,000. A Roth IRA balance of that sort is helpful in retirement cash flow planning and makes an effective wealth transfer vehicle.