For years, I have struggled to understand, and then analyze, the backdoor Roth IRA conversion process. Maybe you have, or maybe you have no idea what a backdoor conversion or even what a Roth IRA is (especially if you are lawyer and make too much to contribute to one in the first place!) So let’s take a look at some definitions and basics from scratch to determine whether the backdoor Roth makes sense for you and your personal finances:
What is an IRA? An IRA is an “individual retirement account.” You can open one quickly at your favorite online brokerage (I use T. Rowe Price). Once you reach the age of 70.5, you will be required to take a mandatory distribution in an amount determined by your age and the then-current value of your IRA account. More on that in a future post.
What is a Roth IRA? Unlike a traditional IRA, a Roth IRA lets you save post-tax dollars in an account that can grow tax-free and, when you make withdrawals in retirement, those withdrawals are also tax-free. Roth IRAs are not subject to mandatory withdrawal requirements during your lifetime but, upon your death, certain distribution rules apply, as do penalties if those rules aren’t followed.
What is a traditional IRA? Anyone can contribute to a traditional IRA up to $5500 per year (if you’re 50 years old or under, $6500 if you’re older than that) regardless of income level. However, your ability to deduct that contribution will depend on your income level. You will not get any deduction if your adjusted gross income is over $119,000. And, once you hit retirement, your withdrawals from your traditional IRA will be taxed as ordinary income at your then-current income tax rate.
Who can contribute to a Roth IRA? For 2017, your adjusted gross income must be below $196,000 if you’re married and filing jointly, or $133,000 if you’re single, in order to contribute to a Roth IRA. However, there is a loophole, which is known as the backdoor Roth IRA.
What is a backdoor Roth IRA? It’s just like a Roth IRA but, thanks to a weird administrative loophole that Congress left in effect back in 2010 when it removed the income limits for IRA conversions, it allows you to convert a traditional IRA account to a Roth IRA account regardless of how much money you make.
What are the mechanics of a Roth IRA? You’ll need to either fund or open a traditional IRA account and then simply convert it into a Roth using the paperwork that you’ll request from your IRA administrator. Sound too good to be true? We’re talking about the tax code here, so of course there’s a catch!
The catch: you might owe taxes upon the conversion. If you deducted your contributions to your traditional IRA and then convert it to a Roth, you’ll need to go back and pay the taxes on them (because only post-tax contributions can go into a Roth IRA) at the time of the conversion. In addition, if you have investment gains in your traditional IRA (maybe you’ve had that account for a while and it has received dividends or other capital gains) then you will need to pay taxes on those as well. This is addressed by the IRS’s pro rata rule, which says you must put all of your traditional IRAs together to figure out how much tax you owe when you convert to a Roth IRA. (But it’s important to note that your current 401k and Roth IRA will not factor into this analysis!)
I find the pro rata rule to be kind of confusing, so let’s look at an example.
Example: Your employer offers a 401k plan, and you’ve saved $40,000 in it. You also have a traditional IRA with a mix of $60,000 in pre-tax, rollover 401k dollars from prior employers, investment returns totaling $20,000, and after-tax contributions in the amount of $20,000, for a total non-Roth IRA balance of $100,000. Finally, you have an old Roth IRA with $5500 in it, which you contributed to after college until you started making too much money. (This is essentially my current situation, just with the numbers changed to make it cleaner and also illustrate the mechanics of how this is supposed to work).
So in our example above, you have a total non-Roth IRA balance of $100,000 and $20,000 in after-tax contributions, only 20 percent of any rollover amount will be eligible for tax-free treatment under the pro rata rule ($20,000 divided by the $100,000 is 20 percent.) And, again, your current 401k and existing Roth IRA, if any, are not part of the analysis.
Now, when you convert that $20,000 into your Roth IRA, only 20 percent of that sum would be tax-free ($4000). You would need to pay taxes on the remaining 80 percent of that amount ($16,000, for a tax bill of $5280 at a 33 percent tax bracket). Similarly, if you wanted to convert your entire $100,000 non-Roth IRA balance, you would owe taxes on $80,000. (At a 33 percent tax bracket, that’s a whopping $26,400 in taxes!)
But there is a way to improve the tax treatment here. If your current employer has a 401k plan and accepts roll-ins, you can move all of that pre-tax 401k money into your current 401k. If you do that in my example, and then want to convert the remaining $40,000, the pro rata rule would give you a 50 percent tax-free conversion ($20,000 divided by $40,000.) So $20,000 will be converted tax-free, and you will owe taxes on the remaining $20,000 (again, at a 33 percent tax bracket, that’s $6600 – a much better result than above!)
If you’re playing with small balances, then, and will pay a small amount of taxes in exchange for the benefit of long-term, tax-free growth, the takeaway here is that the conversion probably makes sense. On the other hand:
Why I haven’t converted (yet): When I first entertained the idea of a Roth IRA conversion a few years ago, I ultimately made the decision that I wanted to defer paying any taxes on my retirement savings for as long as possible. I am in a high marginal tax bracket right now and I would rather let my money grow in my traditional IRA than pay taxes on a relatively large amount of retirement savings and forego what I hope is another 30 years of tax-free growth (even though I’ll need to pay taxes on the withdrawals down the line.)
My hope is that, in retirement, I will find myself in a lower marginal tax bracket. But after working on this article, I may take another, closer look at my current IRA configuration, run the numbers again, and then make a decision on whether to work on a Roth IRA conversion strategy.
What do you think of my decision and this analysis? Have you converted your traditional IRA into a Roth? If not, why?
More reading (these are two of the best articles I’ve found on the Roth IRA conversion process):