All About Roth Part II: Roth Conversion and The Backdoor Roth IRA

Fake columns drawn on the facade of a building to save money in Munich. lol.
Fake columns drawn on the facade of a building to save money in Munich. lol.

So in the first part of my All About Roth series, we talked about some unique features of the Roth IRA and how it can be a great component of your overall investment and retirement strategy along with the fact that the Roth IRA can be used for more than just retirement alone.  But it turns out you make too much money to contribute to a Roth IRA.  Doh!  Well not to fear, because Congress went and left a door wide open for all of us who make too much to still be able to get in on the Roth IRA action when they lifted the income limits on Roth conversions.  Oddly enough, the IRS tells you you can not contribute to a Roth IRA if you have a modified adjusted gross income (MAGI) of $131,000 for a single person and $193,000 for a married couple filing jointly, but you can convert funds into a Roth IRA with no income limits.  This strategy is often called the backdoor Roth IRA.  Strange right?  You might wonder if this is some oversight by the government and they don’t know its going on, but just google backdoor Roth IRA and you’ll see a ton of different articles about it from Kiplinger to Forbes to finance blogs galore.  The government’s not dumb, they know this loophole exists but have yet to close it.  Actually they’re trying.  President Obama just recently made a budget proposal to Congress about closing the backdoor Roth IRA loophole.  This isn’t the first time it’s been proposed to shut down the backdoor Roth IRA either.   I suspect there’s a pretty good chance in the near future there will be no more backdoor Roth IRA’s.  =(

Can you explain what a backdoor Roth IRA is again?  Every year the IRS sets an income limit that prevents those who make over a certain income level from contributing to a Roth IRA.  Why they don’t want high income earners to be able to have a Roth IRA is beyond me.  At any rate, in another strange twist, in 2010 congress lifted the income limit on a Roth conversion.  So the backdoor Roth IRA is to first open a traditional non-deductible IRA since anyone regardless of their income can open one and then to convert the funds in the traditional non-deductible IRA to a Roth IRA.  Simple right?  Sort of.  There’s a few things to watch out for:

Tax liability and the pro-rata rule:  When you open your traditional non-deductible IRA and you plan on converting to a Roth IRA soon, it’s probably best to not invest the money into anything since any investment gains will be taxed when you convert to a Roth IRA.  Generally you want to keep your money in a cash fund like a money market fund (VMMXX)   This will keep your tax liability close to zero when you convert.  However, another tax landmine you might run into is called the pro rata rule.  A Roth conversion is a taxable event and triggers the pro-rata rule in which the IRS views the sum of all your IRA assets (i.e. traditional IRA, SEP-IRA, SIMPLE IRA) as one big IRA for taxation purposes.  You won’t have to worry about the pro-rata rule if you have no other IRA assets.  However, if you do then you should carefully weigh the tax consequences of the pro-rata rule against the benefits of doing the Roth conversion.  The pro-rata rule is a 2 step equation that calculates your tax liability in a Roth conversion.  Generally, the more tax-deferred IRA assets you have, the greater your tax liability and less favorable a Roth conversion might be for you.  There is a workaround for this but yup you guessed it, it’s more work on your part.  You have to roll over your tax-deferred IRA assets into a 401k which can only be done if your employer allows this.  Then you’ve removed the tax-deferred IRA assets from the pro-rata equation making your tax liability zero again.   Looking at an example is probably the best way to see how the pro-rata rule works, so let’s take a look.

Mary already maxes out her 401k at work and now wants to open a backdoor Roth IRA since she makes too much to contribute directly to a Roth IRA, so she opens a traditional non-deductible IRA and contributes $5500 with the plan of converting it to a Roth IRA.  However, she also has $13,000 in another traditional IRA she owns, $10,000 of which was deductible contributions (before-tax) and $3000 of which are her investment earnings.  When Sarah converts her $5500 in her traditional non-deductible IRA into a Roth IRA, based on the pro-rata rule, she must pay taxes on $3865 or 70.3% of $5500.  How did we arrive at 70.3%?  Take all her non-deductible amounts in this case only $5500 and divide by total IRA assets – $5500 ÷ $18,500 = 0.297 which mean 29.7% of her conversion amount is tax-exempt leaving 70.3% of it taxable.  If Sarah wants to circumvent the pro-rata rule, she can see if she can roll her $13,000 IRA assets into her 401k.  Thoroughly confused yet?

The bottom line is if you have no other IRA assets you good.  If you do have IRA assets, the more total deductible IRA assets you have, the more tax you’ll have to pay unless you can roll your IRA assets into a 401k.

Shoot!  I didn’t know about the pro-rata rule and already did a Roth conversion and now I’m going to have to pay too much in taxes!  It’ll probably be ok, because the IRS gives you an out.  It’s called recharacterization and it allows you to undo your Roth conversion back to a non-deductible traditional IRA and all the tax consequences along with it.  Just remember the deadline is October 15 of the year following the year of the conversion.

Is the backdoor Roth IRA legal?  The step transaction doctrine:  Even though technically each individual step of the backdoor Roth IRA is legal, the “sum of the steps” may not be since in essence its basically a way to circumvent the income limits on a Roth IRA.  They call this the step transaction doctrine and people worry it allows the tax courts to recognize a backdoor Roth IRA for what it is and end up taxing you on it anyways.  Several experts have weighed in on how to avoid looking like you are doing a backdoor Roth IRA by suggesting you wait a specific period of time before converting your traditional IRA to a Roth IRA, but how long you wait is up for debate.  There’s no harm in waiting to convert except that your contribution could incur growth during that time and therefore taxes, but the tax liability should be small.  But on the other hand, the faster you convert it to a Roth, the faster you can get your money invested and growing tax free.

Seems like a lot of pitfalls, should I even open a Backdoor Roth IRA?  For the most part I’d say yes, especially if you’re already maxing out your 401k and need another place to shelter your money from taxes and save for retirement, both of which most high income earners need to do.  The best tutorial I’ve seen and actually the one that we follow is by The White Coat Investor, Backdoor Roth IRA Tutorial.  It’s the simplest and easiest to follow in my opinion, especially if you invest at Vanguard, though it can easily be applied to any other financial institution that offers a Roth IRA such as Fidelity, TD Ameritrade, etc.  I also totally appreciate that he shows you how to fill out the form 8606 for tax purposes.  Don’t forget that if you do make any non-deductible contributions to a traditional IRA and/or do a Roth conversion, you must fill out a Form 8606 for every year you do this.  There’s $50 penalty if you fail to fill out a form 8606.  If you’re really afraid of the IRS and the step transaction doctrine then my answer would be no, though the general consensus is that it’s doubtful they’ll prosecute those who have taken advantage of the loophole.  I mean like I said, the government is not dumb, they know this loophole exists, actually Congress created it in 2010 by lifting the income restrictions on Roth conversions.  I think more likely they’ll shut down the backdoor Roth IRA by closing the loophole sometime in the near future, but I also doubt they’ll prosecute all of us who have taken advantage of it.  Still if you feel worried about the IRS coming after you, then don’t do it.  It’s not worth losing sleep over.  Just go and open a taxable account and save that way.  After all, money is just money but sleep, well sleep is a beautiful thing.

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