Summary/TL;DR
Roth IRA contributions are disallowed for taxpayers above certain income thresholds. Fortunately, these higher income individuals can still make contributions via a transaction known as a “backdoor Roth IRA”. This involves making a non-deductible contribution to a Traditional IRA and converting it to Roth. As long as the pro-rata rule is accounted for and Form 8606 is completed correctly on one’s tax return, this will allow you and your spouse to effectively make contributions to a Roth IRA regardless of your income.
Introduction
Roth IRAs have become immensely popular due to the amazing tax advantages that they offer to their owners. Unfortunately, however, taxpayers above certain income thresholds ($161,000 for Single filers and $240,000 for Married Filing Jointly filers) are not allowed to make contributions to a Roth IRA (although they are always allowed to contribute to their employer’s Roth retirement account). In fact, one of the most common reasons I am given for why someone isn’t contributing to a Roth IRA is that they “make too much money”.
Fortunately for these taxpayers, there is a completely legal solution to this problem – the Backdoor Roth IRA Contribution.
Roth Conversions versus Roth Contributions
I always begin explaining backdoor Roths by discussing the difference between a Roth conversion and a Roth contribution. In both a Roth conversion and contribution, the ultimate destination of the funds is a Roth IRA, with the only difference between the two being the source of the funds entering the Roth.
The source of a Roth conversion is always a pre-tax retirement account. The source of a Roth contribution, therefore, would be a non-qualified account. If you’re ever confused about whether or not the transaction being made is a Roth conversion or a Roth contribution, simply ask yourself what type of account the funds are being sent from. If it’s a pre-tax retirement account, you’re making a Roth conversion. If it’s a non-qualified account, you’re making a Roth contribution.
The Anatomy of A Backdoor Roth Contribution
Unlike Roth IRAs, Traditional IRAs have no income phaseouts that disallow one from making contributions to them. Furthermore, Roth conversions have no limitations on who may make them.
Taken together, these facts present an opportunity for high income earners to contribute to their Traditional IRA and convert their contribution to a Roth, the end result being identical to them making an ordinary Roth IRA contribution. Because the source of the funds being deposited into the Roth are from a pre-tax account (a Traditional IRA), this transaction qualifies as a Roth conversion and is therefore disallowed to no one!
Ordinarily, a contribution made to a Traditional IRA is an adjustment (this is different from a deduction) to income on one’s tax return, excluding the amount contributed from taxation. In a backdoor Roth contribution, however, the IRA contribution should not be entered as an adjustment to income. In other words, the IRA contribution is made on an after-tax basis. There is nothing special that needs to be done at the time of contribution, but proper tax filing of this contribution is essential to the success of the backdoor Roth strategy.
Oftentimes, after maxing out employer retirement plan contributions, a backdoor Roth IRA is the next best place to save for retirement. The only real limitation they face is a contribution limit - only $7,000 per year may be contributed to a backdoor Roth IRA, plus another $1,000 for those over the age of 50.
The Pro-Rata Rule
Another important detail involving backdoor Roth contributions is the pro-rata rule, which simply states that if pre-tax and after-tax funds are mixed in a Traditional IRA, then all future distributions from that Traditional IRA will be partially taxable. The amount subject to taxation is proportional to (pro-rata) the amount of pre-tax contributions relative to after-tax contributions in the IRA. In other words, it’s a huge headache that should be avoided.
The only way around this rule is to make sure that all Traditional IRA accounts have a $0 balance by December 31st of the tax year. This is commonly achieved either by converting all Traditional IRA accounts to Roth (common for smaller accounts) or rolling over all Traditional IRA accounts to an employer retirement plan, such as a 401(k). Funds in a pre-tax employer retirement plan are not subject to the pro-rata rule – it is only IRAs that are problematic.
Finally, the pro-rata rule is applied at the level of the individual. In other words, if you are married and aren’t able to clear-out your Traditional IRA, but your spouse is, then your spouse can make a backdoor Roth IRA contribution without any problem.
Form 8606 and Tax Filing
Improper reporting of backdoor Roth IRA contributions is by far the most common mistake I encounter from those who attempt to make one without the assistance of a professional (or, unfortunately, even with the assistance of a professional). Both the after-tax contribution to the Traditional IRA and the subsequent Roth conversion are reported on IRS Form 8606. Failing to do this properly will result in double taxation on the amount contributed to the IRA.
In other words, as with any and everything tax planning, don’t try this on your own!
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