Introduction

Formulate a Financial Plan

Know Your Net Worth

Manage & Minimize Debt

Accumulate Assets

Budget to Live Within Your Means

Understand Investing Basics

Plan for Retirement

Insure People & Property

Deal with Financial Advisors

Review Your Employment Contract

Make Plans for Your Estate

Make Good Decisions

Conclusion

You may have heard of the Backdoor Roth IRA tactic. It’s often touted as a way for high earners to bypass income limits and still be able to contribute to a Roth. The Backdoor Roth is a tactic, not an official type of IRA. The procedure requires you to contribute to a non-deductible IRA and then convert it to a Roth account. Your non-deductible IRA contributions were made post-tax so they are compatible in that sense with Roth contributions which are also made post-tax. Some people suggest that you convert immediately to avoid the account accruing any gains as those would be subject to taxation following conversion. Others argue that immediate conversion risks running afoul of the Step Transaction Doctrine, which could be used by a tax court to argue that your hasty steps are nefarious.

Setting aside the step transaction doctrine, which requires legal opinions from a licensed tax expert, there is another catch. If you already have other Traditional IRA (pre-tax) assets, then the amount of your backdoor Roth IRA that gets the favorable Roth taxation treatment is pro-rated based on the relative amounts of your post-tax and Traditional pre-tax accounts at year-end. For example, if you have $95,000 of pre-tax (Traditional) IRA holdings and $5,000 in post-tax (Non-deductible) IRAs you wish to convert, the percentage of any conversion to Roth that gets true Roth treatment is only $5,000/$100,000 = 5%. This means you will owe income taxes on 95% of the conversion. This pro-rata rule was put in place to ensure the Roth benefit does not go to people who are well-positioned for retirement by already having significant Traditional IRA assets. The rule significantly dilutes the benefit of the conversion.

There is a way to sidestep this pro-rata rule, by getting rid of your Traditional IRA assets. This is possible if your employer-provided 401(k) or 403(b) allows you to roll-in external assets into the account. The idea is that after rolling-in all your Traditional IRA assets into the qualified account, you will have zero pre-tax IRA assets, and the pro-rata rule will not affect you. Keep in mind that 401(k) and 403(b) accounts generally offer fewer investing options, and fees may not be as low as you could find in an IRA. So, you could convert to Roth, but your now larger holdings in qualified employer accounts may be subject to higher annual fees. That represents a drag on your value gains and somewhat undermines the conversion strategy.

An alternative if you own a company is to set up a Solo 401(k) through a provider that allows roll-ins. Then transfer your Traditional IRA assets into that new account, thereby side-stepping the pro-rata rule.

Final thoughts on such conversions: the process is fairly straightforward, but your tax filing must be precise. Any mistakes on your part or on the part of your accountant could lead to headaches, penalty payments, and additional filing costs in future. You or your accountant must properly track the timing of conversions and file IRS Form 8606, titled, “Nondeductible IRAs,” along with any other required paperwork. You should also be aware of the previously mentioned step transaction rule which could be invoked to undermine your contribution-and-immediate-conversion strategy.

I’ve encountered several accountants who were not aware of all the required steps and limitations. You may wish to direct them to some of the relevant links posted below.

 

Related Links:

The Motley Fool: What Is a Backdoor Roth IRA?

Kitces: How to do a Backdoor Roth IRA contribution while avoiding the IRA aggregation rule and the step transaction doctrine

Morningstar Backdoor Roth IRA? Avoid These 6 Mistakes

Nerdwallet Backdoor Roth IRA high-income how-to guide


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