What is a Back Door Roth IRA?

Have you been doing retirement planning recently? I have. My wife is going to be graduating from her nursing program which means I can now retire before I’m 70! Woo Hoo!

To say I’m stoked is the understatement of the year. The reason I’m so happy is two-fold:

  • My wife gets to live her passion and contribute to others outside the family
  • We can finally start catching up our retirement contributions

You see as I stated here , we are parents of 3 special needs kids. Because of this, my wife has been a stay-at-home mom for the past 15+ years to care for our children.

Finally, after a lot of hard work, prayer, and support from both of our families, all my kids are doing tremendously better to the point where she can now go back to work.

Roth IRA

For the last 15 years, we have been a 1 income family. While I make a respectable living, paying the medical and out-of-pocket (OOO) expenses for the children really has taken a toll on our finances and our retirement savings.

As a result, we have been woefully underfunding our retirement to pay for their medical bills. Now that she is going to start working again, this has opened up our financial world!

You see, the good part of our current lifestyle is that I know we can live on just my income. With her now working, we can take her income to not only pay down other bills, but more importantly, supercharge our retirement funds.

I’ve been investigating how to invest our funds once both of our 401K’s and Roth IRAs are maxed out. By accident, I came across a Back Door Roth and dug into it. I was pleasantly surprised by what I found.

What is a Backdoor Roth?

A backdoor Roth IRA is not an official type of retirement account. Instead, it is an informal name for a complicated but IRS-sanctioned strategy for high income taxpayers to fund a Roth IRA even if their incomes exceed the limits for Roth IRA contributions (modified adjusted gross incomes of $140,000 for single filers and $208,000 for married couples filing jointly).

A backdoor Roth basically involves converting a traditional IRA into a Roth variety. When money is converted over from a traditional to Roth IRA, taxes are owed at the end of the tax year that the conversion occurs in. The good part about this strategy is that once converted to a Roth no other taxes are owed for as long as the Roth IRA exists. Also, any growth in the Roth IRA is tax-free and is tax-free upon withdrawal during retirement.

Back Door Roth IRA

This is NOT a tax dodge.  It is an IRS-sanctioned way for high income earners to legally sidestep the Roth income limits that normally restrict them from contributing to a Roth IRA.

Even though you may not have originally qualified to contribute to a Roth, through some fancy administrative paperwork, you can contribute through the backdoor no matter your income level.

The good news is that your money can now grow tax-free… a great perk for when you want to take it out in retirement.

How to Create a Backdoor Roth IRA

Here is a step-by-step guide on how to make a backdoor Roth IRA conversion.

  1. Put money in a traditional IRA account
  2. Convert contribution to a Roth IRA
    1. See your IRA administrator for instructions and paperwork to complete.
  3. Pay taxes on converted funds
    1. Don’t use money from your IRA conversion to pay for taxes. This eats into the IRA principal.
  4. Rinse and repeat each year

Here is a pictorial for how it works that I found on ODs on Finance.

Back Door Roth IRA Process

Ever Hear of a MEGA Backdoor Roth IRA?

If you think a backdoor IRA is a sweet deal, wait until you investigate a MEGA backdoor IRA!

A mega backdoor Roth IRA is a tax strategy that can be used to dramatically increase contributions to a Roth IRA and bypass the usual Roth IRA income limits. As with any Roth, your money grows without being taxed and the funds can be drawn tax-free in retirement.

You can make a mega backdoor Roth contribution if:

  • You have a 401K plan at your work
  • Your 401K plan allows after-tax contributions
  • Your 401K plan permits in-service withdrawals or rollovers

If you meet all the rules and requirements, an additional $38,500 a year can be saved in a Roth by putting after-tax funds into the 401K and then rolling it over to the Roth IRA.

The most that can be contributed to a 401K on a pre-tax basis is $19,500 if under the age of 50 and $26,000 if over the age of 50.  However, the overall IRS-allowed limit on 401K contributions is actually $58,000 ($19,500 + $38,500) if under the age of 50 and $64,500 ($26,000 + $38,500) if over the age of 50. Nice huh? 😊

Here’s How It Works:

After pre-tax contributions have been maxed out, an additional $38,500 in after-tax contributions can be accumulated. Next, transfer that $38,500 in after-tax contributions to a Roth IRA so long as your 401K plan allows in-service distributions or rollovers.

What about my employer match?

If you receive an employer match, this counts against the maximum total contribution. For example, if you contribute $19,500 and receive $10,500 from your employer as a 401K match, that counts as $30,000 towards the $58,000 limit. Thus, you can only contribute an additional $28,000 ($58,000-$30,000) in after-tax money that can be rolled over to the Roth IRA.

Here is a pictorial from Next Level on how a mega backdoor IRA and Roth IRA contribution can combine to work for you:

Special Considerations for a Backdoor Roth IRA

When attempting a backdoor Roth IRA conversion, you need to be aware of some quirks.

Five-Year Rules for Backdoor Roth IRA’s

The 1st five-year rule states that in most cases, even if over 59 ½, you cannot withdraw Roth IRA earnings free of taxes and penalties unless the first Roth IRA contribution was made at least 5 years ago.

The 2nd five-year rule states that no funds can be accessed from the converted Roth IRA without penalty for the first five years after the conversion. In other words, if a backdoor Roth IRA conversion is done every year, a person must wait five years to tap into each portion that is converted. If this is not followed, there is risk of paying additional penalties on money already taxed.

There are exceptions to this requirement if you’re 59 ½ or older, if a person becomes disabled, or if a person passes away.

Traditional IRA’s That Hold Previously Deducted Contributions

The IRS views all of your traditional IRAs as a single account when determining taxes owed on distributions. These distributions also include Roth IRA conversions. This is known as the aggregation rule. All IRAs are regarded in the aggregate.

This means that a person may owe taxes on money intended for a backdoor Roth IRA conversion even if the money has already been taxed. This can complicate backdoor Roth IRA conversions for people with existing traditional IRA account balances.

Taxes may be owed on money intended for Roth IRA conversion even if the money was already taxed. This can happen when the IRS’s aggregation rule intersects the pro-rata rule.

The pro-rata rule states that taxation of IRA accounts when converted either partially or fully to Roth accounts will be calculated proportionally to the fraction of after-tax vs before-tax contributions. The percentage of funds that are yet to be taxed will be taxed at the pro rata rate, regardless of whether one or all IRA accounts are transferred

For example, assume 70% of the funds in your four combined IRA’s earned tax deductions (pre-tax contribution) and 30% did not earn any tax deduction (after-tax contribution). When undertaking a back door Roth IRA conversion, the already taxed funds cannot be separated out. In this example and due to the pro-rata rule, 70% of the money being converted to a Roth IRA would be taxed in the Roth IRA conversion regardless of which account it comes from.

Backdoor Roth IRA’s – Pros and Cons

There are both advantages and disadvantages to using the backdoor Roth IRA strategy.

Here are the advantages:

  • No income limit to start a traditional IRA – Everyone who earns an income is eligible for a traditional IRA
  • No limit to the amount of money that can be transferred from traditional to Roth IRA at any one time – You could potentially pay a hefty tax bill, but if you had the cash to cover it, who cares!
  • Tax-free gains and withdrawals – If a traditional IRA is converted to a Roth IRA, taxes are paid up front. This should be, in theory, less taxes to be paid now versus what would be paid if taxed down the road post-growth. Less tax payments means more money in your pocket at withdrawal time! Plus, Roth IRA’s enable tax-free withdrawals in retirement since taxes were paid up front at inception not at the end when the account is the largest.

Here are the disadvantages:

  • Make sure to have the cash on hand to pay the tax bill when the Roth IRA conversion occurs. DO NOT use investment money to pay the tax bill. The more money you can have invested, the more you will have at retirement.
  • You can only invest $6,000 each year into an IRA ($7,000 if 50 or older) regardless whether it is traditional or Roth.

So What Do You Think?

There you have it. All the things you need to know to create a backdoor Roth IRA. Pretty sweet huh? 😊

One thing to keep an eye on in the coming months is Congress and the current bill Biden is trying to get passed. As part of his overall plan to pay for the infrastructure improvements he want to undertake, he wants to close the tax loopholes that enable this wonderful financial tool to occur.

Roth IRA

Congress is looking for ways to raise taxes on the wealthy in order to fund the upcoming government spending. While it won’t be an immediate financial boon, it could provide future governments with more money as retirement savers are forced to put more of their savings in taxable investment accounts.

When those investments grow and account holders sell to fund their retirement, the government collect the taxes.

While Biden promised not to raise taxes on families making less than $400,000 per year, there is a BIG gap between funding a backdoor Roth and $400,000 per year.

This is something I plan to keep an eye on in the coming months.

Thoughts? Comments? I’d love to hear from you. Please post your comments here.

Live the Life You Love, Want, and Deserve 😊