Backdoor Roth IRA Contributions
By Kaye A. Thomas
Current as of February 14, 2015
This article is adapted from our book, Go Roth!
Congress made a peculiar choice, eliminating the income limitation for Roth conversions while leaving it in place for Roth IRA contributions. Under these rules, someone who wants to contribute to a Roth IRA but has too much income may be able to accomplish a similar result by contributing to a traditional IRA and then converting that amount to a Roth. This technique, which has come to be known as the backdoor Roth IRA contribution, can be effective in the right situation, but it isn’t quite as simple as it sounds.
Who can benefit
The backdoor contribution is most often used by people who can contribute to a traditional IRA but (1) can’t claim a deduction for that contribution due to their income level and participation in an employer plan, and (2) can’t contribute to a Roth IRA because of their income level. Note that you need to have qualifying income (generally wages or other earnings produced by working). You also have to be below the age of 70½. This is not a requirement for a direct contribution to a Roth IRA, but a backdoor contribution requires you to begin with a contribution to a traditional IRA, which imposes the age limit.
If you’re in this situation, it’s definitely preferable for the money to be in a Roth IRA instead of a traditional account, because neither account will provide a deduction for the contribution but only the Roth will allow the investment earnings to be entirely tax-free.
No existing TIRA
The backdoor contribution works best for people who have no existing traditional IRA. You would make a nondeductible contribution to a new TIRA, then convert it to a Roth. You would pay no tax on the conversion unless the account produced earnings during the small interval of time between the contribution to the traditional IRA and conversion to a Roth. That means the tax consequences are pretty much the same as if you had been allowed to contribute directly to the Roth.
Backdoor for TIRA owners
Things get more complicated if you already have a traditional IRA. This is because of the infamous aggregation rule. When you take money from a traditional IRA, whether it’s a regular withdrawal or a conversion, you determine the tax consequences by treating all your traditional IRAs as if they were one big IRA. This means you may have to pay tax on the Roth conversion when using the backdoor method, even if the account you’re converting has never had any deductible contributions or investment earnings.
Example: You have a $20,000 traditional IRA from an earlier 401k rollover, and all the money in that account is pre-tax. You want to make a $5,000 backdoor Roth contribution, so you set up a new traditional IRA, contribute $5,000, and convert it to a Roth the next day.
You have to add all your traditional IRAs together to figure the tax consequences of the conversion. You have $20,000 of pre-tax money in one IRA and $5,000 of after-tax money in the other. That makes a total of $25,000, and 80% of that amount is pre-tax. Result: when you convert $5,000 you pay tax on 80% of that amount, or $4,000. This isn’t a complete disaster, because it also means you now have $4,000 of basis in your traditional IRA that will eventually come out tax-free. It’s probably not the result you intend, though.
No required waiting period
There is no required waiting period between the date you contribute to a traditional IRA and the date you convert it to a Roth. I recommend that you obtain positive confirmation that the money was deposited in a traditional IRA before converting it to a Roth, and in any event do the conversion at least a day later than the contribution so there is a paper trail establishing that you performed both of the required steps. You don’t want to leave open the possibility for the IRS to argue that the money never settled in the traditional IRA, causing it to be treated as a regular (and impermissible) contribution to a Roth.
Some people have suggested that the IRS might challenge the tax consequences of a TIRA contribution closely followed by a Roth conversion. We address this issue in our article Possible Legal Challenge to Backdoor Roth Contribution.