Don’t Let a Backdoor Roth IRA Become a Trapdoor IRA
February 03, 2016Updated February, 2018
I was talking with a married couple the other day who were happy that they both made high incomes but unhappy that they could not contribute to Roth IRAs and enjoy some tax-free income later in retirement. According to IRS rules, married couples who file their taxes jointly cannot contribute to a Roth IRA when their combined incomes exceed certain amounts.
However, they perked up a bit when I mentioned the possibility of still contributing to a Roth IRA – even with their high incomes – using an idea called a “backdoor” Roth IRA. It works like this: even though the IRS has an income limit on Roth IRA contributions, there is no income limit on Roth IRA conversions from a traditional IRA. So step one would be to open traditional IRAs (one for each of them) and contribute up to the annual maximum amount to each traditional IRA.
Step two would then be to convert their freshly funded traditional IRAs into Roth IRAs and pay tax on any growth that took place inside the traditional IRAs between the time they deposited money into them and the time they converted them to Roth IRAs (which should be close to nothing, assuming the steps are done within a week of each other). That’s how the “backdoor Roth IRA” works in its simplest form. But there may be a catch…
Pre-existing traditional IRA balances complicate matters
As with any financial strategy that may sound a little too good to be true, the backdoor Roth IRA strategy comes with an expensive gotcha if not done properly. Thanks to the IRS pro-rata rule, taxes on a converted traditional IRA are due not just on the funds being converted, but may also be due on any other non-Roth, never-taxed IRA monies, too.
As with any financial strategy that may sound a little too good to be true, the backdoor Roth strategy comes with an expensive gotcha if not done properly
For instance, suppose you also had a 401(k) from a previous job worth $45,000 that you rolled into a traditional IRA after leaving that job. Using the backdoor Roth IRA strategy, you deposit $5,500 of after-tax money into a separate traditional IRA and then quickly convert that $5,500 to a Roth IRA.
At first, it seems this conversion is tax free since the $5,500 traditional IRA didn’t grow to more than the original $5,500 before you converted it to a Roth IRA. The catch is that the pro-rata rule requires you to consider all untaxed traditional IRA money that you have, not just the money that you are converting when calculating any tax you may owe on the conversion.
Running the numbers
In this case, the after-tax $5,500 IRA contribution would be approximately 11% of your total traditional IRA funds ($5,500/[$45,000 + $5,500]), which means the IRS will assess taxes due against 89% of the $5,500 conversion. Instead of a $5,500 Roth IRA conversion that was more-or-less tax-free (no growth in the account yet), you will instead owe taxes on just over 89% of the $5,500 or $4,895, which would be taxed as ordinary income.
Avoiding the trapdoor
So how does one avoid this backdoor trapdoor? Ideally, anyone considering a backdoor Roth IRA should avoid rolling over any old 401(k) dollars into a traditional IRA until the calendar year after the conversion. If you’re going to use this as an ongoing strategy, you could either leave old 401(k)s in their old plans or roll them into your existing 401(k). If you’ve already rolled an old 401(k) into an IRA, you may be able to roll these funds into your current 401(k), assuming the plan allows for these incoming rollovers.
What if you have a traditional IRA that you’ve made past contributions into from years past? Well, you’re out of luck. You can still do the backdoor Roth IRA, but it won’t be tax-free.
Even though your income exceeds the limits, you can still contribute to a Roth IRA. You just have to use the backdoor. However, the key to a tax-free backdoor Roth IRA contribution is making sure there are no other untaxed traditional IRA dollars lurking in the background, ready to turn your backdoor Roth IRA into a taxable trapdoor IRA.
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