**This post originally appeared here, on abovethecanopy.us
If you asked me to choose my FAVORITE type of account to invest in, it would definitely be the Roth IRA. Roth IRAs allow you to save money tax free for the rest of your life. They’re not subject to mandatory withdrawals in your 70’s, and your kids won’t even owe taxes on their withdrawals if they inherit the account from you down the road. In my opinion the Roth IRA is just about the best deal out there.
Problem is, they’re not accessible to everyone. The IRS considers Roth IRAs such a good deal that they won’t let you contribute to one if you make too much money. Fortunately, there’s a work around: the backdoor Roth IRA conversion. The backdoor Roth conversion allows you to get money into the Roth IRA by making non-deductible contributions to a traditional IRA. Don’t worry if this sounds complicated. This post will cover exactly how the strategy works and when you might consider using it.
The Backdoor Roth IRA Conversion Strategy
So here’s how it works. I’ll break it down into two-distinct steps. But to start, let’s review the income limitations for direct contributions to a Roth IRA. If your modified adjusted gross income on the year (MAGI) falls below the “Full Contribution” threshold (see below), you can contribute to a Roth IRA directly - and therefore have no need for this strategy. As your MAGI creeps into the phaseout region, your contribution limit for the year begins to fall. When it reaches the “Ineligible” threshold, you’ll be prevented from contributing to a Roth IRA altogether (at least in 2018). If this is you, the backdoor Roth conversion might be a good fit. (Here’s a review of how to calculate modified adjusted gross income).
Step 1: The Contribution
Let’s say that thanks to your MAGI, you do make too much to contribute to a Roth IRA directly. That means your MAGI would fall above $135,000 as a single filer, or $199,000 if you're married filing jointly.
The rules for the traditional IRA are somewhat similar. Whereas you're always free to contribute funds to a traditional IRA, you'll only be able to deduct those contributions if your MAGI falls below certain thresholds.
Here's an Example:
Hypothetically, let's assume that you're a single filer who pulls in $50,000 in MAGI on the year. Your income falls below the phaseout range for Roth IRA contributions and traditional IRA deductions. You'd have two main options:
Make a non-deductible contribution to a Roth IRA
Make a deductible contribution to a traditional IRA
On the other hand, let's assume the following year is phenomenal for you earnings wise, and your MAGI jumps 400% to $200,000. You'd now fall above the income thresholds, and your options would be limited:
You're no longer eligible to contribute to a Roth IRA. You made too much money.
You could still make a contribution to a traditional IRA. But since you made too much money it wouldn't be deductible.
This is where the "conversion" part (step 2) comes into play. Although the IRS uses your income to limit contributions to Roth IRAs, there are no limits whatsoever on conversions. Regardless of your MAGI for the year, you're free to convert assets you have in a traditional IRA to a Roth IRA whenever you want. The difference between the amount you're converting and your basis in those assets is then added to your adjusted gross income for the year.
In this context, basis means "what you paid income tax on". When you make non-deductible contributions to a traditional IRA, you establish a cost basis in that contribution. This is important for the tax treatment of your account in the future (and essential for the backdoor conversion to work). When you take distributions from the account later on (or convert it to a Roth IRA), you'll owe tax on the difference between your total distributions for the year and your cost basis.
Let’s look at this from another angle. Let’s say you make a $5,500 contribution to a traditional IRA. You file as a single person and your modified adjusted gross income is $50,000 for the year. Since you're below the income limitation you may deduct the $5,500 contribution on your tax return, leaving you with a basis of $0. Let's also say you leave it alone, and it grows to $20,000 by the time you’re 65. If you withdrew the entire balance, you’d owe income tax on the difference between the amount of your withdrawal and your basis: $20,000 – $0 = $20,000. So, $20,000 would be added to your income for the year.
But if instead you didn’t deduct your initial contribution to the account (because your income was above the threshold and you weren't eligible to) you’d have a basis in the account of $5,500. Future withdrawals of $20,000 would add $20,000 – $5,500 = $14,500 to your taxable income. You’re only taxed on the gains above your cost basis.
Step 2: The Backdoor Conversion
Just like a withdrawal from an IRA, a conversion from a traditional to a Roth IRA adds the conversion value above your basis to your income for the year. So, using the example above, if you decided to convert your traditional IRA to a Roth IRA instead of withdrawing it, you'd still have $14,500 added to your taxable income on the year.
But what if you converted your balances in the account before they appreciated? Since there is no limitation to the timing or amount of Roth IRA conversions, you could make a non-deductible contribution to a traditional IRA, then convert it to a Roth IRA immediately afterward. And since the account balance equals your basis there would be no tax impact: $5,500 - $5,500 = $0.
This is the back door Roth IRA conversion. Even though your modified adjusted gross income is too high to contribute to a Roth IRA directly, you can still get in through the backdoor.
Logistically, you’d need both a traditional and Roth IRA opened at the brokerage firm holding your accounts. Most brokerage firms are familiar with the strategy, and can help you shuffle funds into your traditional IRA and then over to your Roth IRA.
Beware though that brokerage firms are not in the business of giving tax advice (just read a few lines of ANY of their disclosures). They’ll certainly be able to help with the logistics, but will not be experts on the potential pitfalls. I’ll cover the finer points below, but I normally suggest that anyone interested in this strategy do so with the guidance of an adviser/financial planner. Using this strategy hastily could put you at risk of penalty.
Pitfalls When Executing a Backdoor Roth IRA Conversion
The Step Transaction Doctrine
The step transaction doctrine is the legal principal that a series of related steps are treated as one individual transaction. So, even though the internal revenue code allows each individual step in a backdoor Roth IRA conversion, the sum of the steps could be interpreted as a direct contribution to a Roth IRA.
This would be fine if your MAGI falls below the phaseout region. But since it probably doesn't if you're considering this strategy, the series of steps could land you in hot water during an audit if challenged by the IRS. More specifically, the IRS would likely impose a 6% excess contribution penalty - for every year the excess contributions remain in your account. (Ouch!).
To avoid this issue, I typically recommend to my clients that backdoor conversions be executed over a period of several years. Remember – the doctrine is imposed when it’s determined your intent is to contribute directly to a Roth IRA. Taking the steps one at a time, with a tax reporting cycle in between them, helps you establish each step as a separate transaction.
This waiting period has been the subject of a lot of debate over the last few years, though. Ed Slott is steadfast in his recommendation to only wait one month. Others, like Michael Kitces, think a year is fine.
The IRS has been quoted as saying “there’s no caveat in waiting” when it comes to the step transaction doctrine for backdoor Roth conversions. But as Kitces points out, IRS enforcement is only part of the equation. While your decision to wait may help you avoid initial scrutiny, if you do wind up in trouble your argument will be in front of a tax court. Not an IRS agent.
Even though the guidance from IRS representatives is helpful, they cannot forecast how a tax court may interpret the situation. Putting your contributions “at risk” for a longer period of time can only strengthen your case that a contribution and conversion were separate transactions.
Ultimately, I’ve not heard of a case where the IRS has scrutinized backdoor Roth conversions. Nevertheless, there’s no reason to take the risk. A $5,500 contribution growing at 10% per year would become $6,655 after two years. By playing it safe you’d only be adding an additional $6,655 – $5,500 = $1,155 to your taxable income, and still taking full advantage of the Roth IRA account when you otherwise wouldn't be eligible to.
The Pro-Rata Rule
The second pitfall that often thwarts would-be backdoor Roth converters is the concept of IRA aggregation. According to IRC rule 408(d)(2), when determining the tax consequences of a distribution you must treat all your IRAs as one aggregated account. This means that if you have several other IRAs, you won’t be able to “carve them out” of the tax calculation for a backdoor Roth conversion. This can become a big issue if you have pretax assets in IRAs already.
Here’s an Example:
Let’s say that you have $100,000 in an IRA, resulting from the rollover of a 401(k) from an old employer. Since you deducted your contributions to the old 401(k), you have a cost basis of $0 in your IRA.
If you wanted to execute a backdoor Roth conversion, you’d contribute $5,500 to an IRA. The contribution could be into the same IRA, or another – it doesn’t matter. Thanks to the pro-rata rule, you’ll need to include both balances when performing the conversion. That means that your total balance across all IRAs is now $105,500. And since you only paid tax on the most recent contribution, your basis is $5,500.
It also means that when executing the conversion, you’d need to use the ratio of total basis to total market value, across all your IRAs: $5,500 / $105,500 = 5.21%. Consequently, any Roth IRA conversion would include 5.21% in after tax funds, and the rest in pre-tax funds. When converting $5,500, $286.55 would be tax free ($5,500 * 5.21%), and the remaining $5,213.45 would be added to your tax bill for the year.
This means that having preexisting pretax assets in IRAs dilutes the value of the backdoor conversion. That said, there is a workaround here too, if you have access to a workplace 401(k) plan. Many plans allow you roll assets in from an external IRA. Doing so here would enable you remove your pre-tax funds from the equation altogether. Using the previous example, rather than having the $100,000 rollover funds dilute the value of the conversion, you could roll the funds back in to your current employer's 401(k) plan. After that year's contribution, you'd only have $5,500 across all your IRAs, with a basis of $5,500. (Keep in mind, though, that the funds you roll into a 401(k) may be locked there until you separate from service. This depends on the plan, of course).
Other Notes: Keeping Track of Non-Deductible Contributions
When you do eventually convert your IRA assets to a Roth IRA, the IRS will assume your basis in IRA assets is $0 unless you tell them otherwise. For that reason, it's important to keep track of your non-deductible contributions each year by filing Form 8606 with your tax returns. This will establish a basis with your contributions.
If you fail to file the form, the IRS will have no record of your basis, and try to tax you twice when it comes time for the conversion. It's not catastrophic if you forget to file it one year though - this form can be filed retroactively if necessary.
When to Use the Backdoor Roth IRA Conversion
As I mentioned at the beginning of the post, I'm a huge fan of Roth IRAs. Depending on the circumstances, of course, most people who have earned income and are saving for the future should strongly consider contributing to one. If you're below the income threshold, do it directly. If you're not, consider a contribution through the back door.