What is a back door Roth?

A back door Roth is a strategy that allows high-income individuals to contribute to a Roth IRA even if their income exceeds the limits set by the IRS for direct Roth IRA contributions.

How does a back door Roth work?

For investors who are not eligible to contribute to a Roth IRA because their income is too high, one strategy to consider is a “Back door Roth.” A back door Roth IRA is a legal way to get around the income limits that typically restrict high earners from contributing to a Roth IRA.

Unlike tax-deferred 401(k) and 403(b) plans, investors can access their Roth IRA principal contributions (money that they put into their account) tax-free before retirement without a penalty. They can even access Roth conversions tax-free after five years.

When it comes to getting more money into a Roth IRA, we highly recommend consulting a financial planner or personal tax professional regarding the strategies above. There may be significant tax implications if not done properly.

What is a back door Roth conversion?

Many retirement savers who aren’t eligible for a Roth IRA do a conversion to reduce the taxes they pay in retirement by moving their money from a traditional IRA to a Roth IRA. This strategy is known as a Roth conversion. It’s also sometimes called a back door Roth IRA conversion because it allows people who aren’t ordinarily eligible for a Roth IRA due to their income to set one up by “sneaking in the back door,” so to speak.

Is the back door Roth going away?

The Build Back Better bill of 2021 originally included a proposal to eliminate the back door Roth IRA strategy. The final version of the bill that was passed, however, did not remove the back door Roth opportunity.

The back door Roth opportunity is still available. If you are not eligible to put money into a Roth IRA, you can still make a contribution into a traditional IRA and then convert that money into a Roth IRA, and pay taxes now, so that your contributions can grow tax-free.

Back door Roth IRA steps

Step #1: Contribute after-tax money into a traditional IRA, which has no restrictions for high-income earners.

Step #2: Convert money from your traditional IRA into your Roth IRA.

Step #3: Enjoy knowing you have more money in your Roth IRA that could be accessed completely tax-free.

How do you do a back door Roth IRA?

Here’s how to do a back door Roth IRA:

Source: https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-iras

How can Roth IRA conversions impact your tax bill?

Many retirement savers are unaware that Roth conversions can trigger a tax bill because of the complicated Pro-Rata rule.

When might you pay taxes on a Roth conversion?

The taxation on your Roth (back door and non-back door Roth conversion) can vary based on a couple of factors:

#1. Growth on after-tax money

If you only have after-tax money in all of your IRA accounts, you may be subject to taxes if there is a gain in your account(s).

For example, let’s assume you contribute $6,500 into your traditional IRA with after-tax money (i.e., you don’t take a deduction on your tax return for the contribution).

Let’s also assume your financial advisor sends you the conversion form, and you forget to sign it for one month. By the time you finally get around to signing your Roth IRA conversion form, the account is valued at $7,500 at the time of the conversion.

In this scenario, you would owe taxes on the gain:

$7,500 (value at the time of the conversion)

– $6,500 (after-tax contribution)

$1,000 (gain)

The gain is taxed at your ordinary income tax rate.

If there is no gain in the same scenario, or a loss, the entire conversion would be tax-free.

#2: IRS Pro-Rata Rule

Some IRA owners incorrectly assume that they can execute a back door Roth IRA strategy without any tax implications.

Taxes on the Roth IRA conversion may apply if the IRA owner has any pre-tax dollars in any of their IRA accounts during the year of the conversion due to the pro-rata rule.

This pro-rata rule requires that investors pay taxes on their Roth conversion when they hold pre-tax dollars in their IRA at the end of the calendar year.

  • The pro-rata rule formula is as follows:

(a) Total of after-tax dollars in all IRA accounts ÷ (b) total of all IRA accounts x (c) amount of conversion

To illustrate how this formula works, let’s assume that Susan has 2 IRA accounts:

Account #1 – holds $93,000 from a pre-tax 401(k) rollover

Account #2 – holds $7,000 from an after-tax IRA contribution

Let’s also assume that Susan converted $7,000 from her second account into a Roth IRA.

  • Here is how the pro-rata formula would work:

(a) $7,000 (total after-tax dollars in all IRA accounts) ÷ (b) $100,000 (total of all IRA accounts) x (c) $7,000 (amount of conversion).

 In this example, $490 or 7% ($7,000/$100,000) of the $7,000 conversion would not be taxable. Susan would have to pay taxes on $6,510 or 93% of the conversion.

When is the pro-rata formula calculated?

The formula is calculated on December 31st during the year of the conversion, not on the date of the conversion. This means the taxable amount can change based on market fluctuations. Additionally, a rollover from a 401(k) or 403(b) into an IRA before December 31st could impact the pro-rata calculation – even if the conversion took place before the rollover.

Can you get around the pro-rata tax if you have two IRA accounts, and only convert the IRA that received an after-tax contribution?

The short answer is “no”. The IRS does not care which account is converted. The pro-rata rule looks at the value of all IRA accounts at the end of the year.

How do I report or track my after-tax contributions for tax reporting?

You or your accountant needs to file IRS form 8606 to track your after-tax contributions and distributions. Also, you need to file that form when you make a rollover that holds after-tax funds (e.g., 401(k)).

What if I forgot to file form 8606?

You or your accountant could file an amended tax return.

What is a mega back door Roth?

A mega back door Roth is a back door Roth strategy that some 401(k) participants may have access to. However, not all 401(k) plans allow participants to utilize this strategy.  For 2023, the maximum mega back door Roth amount that can be contributed is $66,000 ($73,500 for those age 50 and older), which is the IRS maximum allowed for all contribution sources.

How to execute a mega back door Roth in 2023

To execute a mega back door Roth, your 401(k) plan needs to allow the following:

  • After-tax contributions above the $22,500 pre-tax contribution limits set by the IRS
  • Ability to make in-plan conversions to a Roth IRA or in-service distributions or withdrawals (non-hardship)

You can ask your plan administrator whether your 401(k) meets these criteria. You could also forward your plan documents to your financial advisor or your accountant to review the plan features with you to determine if your plan gives you the ability to use the mega back door Roth strategy.

How can you lower the potential tax bill related to your back door Roth IRA strategy?

Some options to consider with your advisor might be to move IRA dollars into a 401(k), if that’s an option within your 401(k) plan. This is also known as a reverse rollover. Moving money from an IRA into a 401(k) can lower the amount of the taxes due on a Roth conversion.

However, keep in mind that a reverse rollover has some potential disadvantages. For example, moving funds from your IRA to your 401(k) may limit your ability to access funds prior to age 59.5 without a penalty. Additionally, you may also be limiting your investment choices, as many 401(k) plans have limited investment choices.

At One Life Financial Group, we highly recommend consulting a financial planner or personal tax professional regarding back door Roth strategies before taking any action. There may be significant tax implications if your strategy is not carried out properly.

There may also be exceptions to the conversion and pro-rata rules that are not discussed in this article.

One Life Financial Group does not offer tax planning or legal services but may provide references to tax services or legal providers. One Life Financial Group may also work with your attorney or independent tax or legal counsel. Please consult a qualified professional for assistance with these matters.

Do you need assistance completing a retirement distribution and Roth conversion analysis?

Roth IRA conversions don’t make sense for everyone. At One Life Financial Group, we believe it’s imperative to complete an analysis before implementing any conversion strategies. Schedule a complimentary consultation and let us customize your plan.