Conversions, Back Doors... what's the deal with Roths?

I’m consistently asked about Roth IRAs and whether or not they make sense from a tax perspective. Sometimes the question stems from it being offered within a 401(k), which I specifically address in this blog. But other times it’s just the desire to open up a plain vanilla Roth IRA.

The first question may not be whether it’s “right” for you, but whether you’re eligible to even open one at all. Roth IRAs have eligibility phaseout that’s tied to income (modified AGI). As a married filing jointly couple, the phaseout starts at $204,000 for 2022. $129,000 if single or head of household. Figure out here if you’re eligible for a full or partial Roth IRA contribution.

If your income lands below these thresholds, then you may directly contribute to a Roth IRA hassle free. In 2022, you may add $6,000, with a $1,000 catchup if aged 50+. But what if you’re unsure where your income will officially land? You may be right on the line based on your best estimates prior to year-end. The good news is you can make a prior-year contribution the earlier of filing your tax return or April 15 (sorry to those who file extensions – you get no additional time). For example, if you file your tax return in March 2023 and determine your income is under the income phaseout, you have until that time to make a Roth IRA 2022 contribution.  

What happens if you’re OVER the income phaseout.

This is where things get tricky, but never say never. Many of my clients are over the income phaseout threshold which is when we discuss the idea of an annual back-door Roth Conversion. For this to be effective, it’s ideal to have no existing IRAs. 401(k)s, 403(b)s, TSP – or any employer retirement plan is fine. But if you’ve rolled over an employer plan to an IRA to have better investment management options, then this may not be your best bet. It may also not make sense if you have other pre-tax or goal funding avenues available, like an HSA, 529, deferred comp, ESPP, etc.

If you have no existing IRAs or competing goals to fund, the steps are as follows:

  1. Open a Traditional IRA and Roth IRA at your preferred custodian.
  2. Contribute to the Traditional IRA, up to $6,000 (+$1,000 if age-eligible)
  3. Leave this contribution uninvested. Cash is perfect.
    1. This is imperative. If invested, any growth will be taxed at conversion. While likely de minimis, it complicates the process. This is also why having an existing IRA is troublesome. The IRS will consider all IRAs to be a part of the conversion. You can’t pick and choose what money you want converted; the IRS will do a pro-rata calculation. So if you have a large existing balance, the conversion will be mostly taxable.
  4. Do not claim this contribution as a deduction on your taxes. It will be considered non-deductible.
    1. For background: The IRS doesn’t limit how much you can invest in a traditional IRA based on how much you earn. Instead, phase-outs determine whether your income restricts you from claiming a full tax deduction for your traditional IRA contribution. Therefore, adding to the IRA when you’re over the income limits simply means you can’t deduct it – which is just fine as this is basically the same difference as adding to a Roth from a tax perspective in the year of contribution.
  5. Ask your custodian for the best time period to leave in place, I’ve generally been advised that 3-4 weeks is ideal as that is often enough time for it to produce a statement to document the contribution first living in the IRA. But defer to your custodian’s recommendation.
  6. File the custodian’s provided Conversion form to transfer the contribution from the IRA to your Roth IRA.
  7. File form 8606 with your tax return to document the contribution and subsequent conversion to the Roth IRA.
  8. Rinse and repeat each year that you’re not able to directly contribute to a Roth.

Want to see this visually – click here!

Why not just leave the non-deductible contribution in the IRA?

You may be wondering, if the non-deductible IRA and Roth IRA contribution are essentially the same difference for tax impact in the year of contribution… why bother with the backdoor conversion?

Unlike non-deductible IRA contributions, Roth IRA accounts treat any eventual distributions as tax-free. Meaning any growth on the contributions escape both ordinary and gains tax.

Non-deductible IRA contributions treat growth as ordinary income which is taxed at the time of distribution. From experience I can say this is a huge pain in the butt logistically once you reach retirement. Typically, IRA money is all pre-tax contributions so the entire distributed amount is taxed as ordinary income. But when you mix in non-deductible contributions, you have to make your CPA aware of the non-deductible balance to ensure it’s not taxed again at distribution. Even if the whole IRA is made up as non-deductible contributions, the growth is still taxed so calculations on how much is taxable need to be made each year. This information can easily get lost when you switch CPAs or tax software, or ends up not communicated to the CPA during your retirement years (especially if it’s been a long time since making those non-deductible contributions).

To further explore your goals related to a Roth IRA and more, please feel free to schedule a call.