Episode 84: The Back Door Into The Beautiful Roth IRA

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This week’s episode is a continuation of last week’s episode about the beautiful Roth IRA.

The big benefit of the Roth IRA is that you fund it with after-tax money and it grows tax free, and then when you take it out, it is also tax free, if you meet the qualifications.

The big problem with a Roth IRA is that there are income limits to be able to make contributions to a Roth IRA. There are a lot of people out there who can’t contribute to a Roth IRA. So, how do you contribute to a Roth IRA if you make too much money? You use a backdoor Roth IRA.

The backdoor Roth IRA makes a lot of sense for individuals who are over the income limit to contribute to a Roth IRA, but there are a few extra considerations that you need to get right. You do have to be very careful because the company helping you with the backdoor Roth is not going to make sure you do it right.

What is the backdoor IRA? At its heart, it is just a conversion. The IRS will allow you to convert traditional IRA assets to Roth IRA assets at any time. The only problem is that as soon as you make that conversion, it all becomes taxable in that tax year. Now, you don’t pay a penalty on that, because you’re not taking a distribution, but you will pay taxes.

Here’s how it works: You make a non-deductible (after-tax) contribution to a traditional IRA. (You couldn’t contribute pre-tax money because you’ve exceeded the income limits.) Then you turn around and convert that after-tax contribution into a Roth IRA. Sounds simple, right?

Here’s the trick, though, if you have both pre-tax and after-tax money in that account: There’s an aggregation rule that says that if you have, for example, $100,000 in an IRA, and that includes both pre-tax and after-tax money, and you want to convert $10,000 of it into a Roth IRA. You don’t get to designate which money you’re taking out, so 1099 is going to reflect a pro-rata amount of that conversion as taxable. The pro-rating is based on the portion of your IRA balance that is pre-tax and after-tax money.

Then, it can get even more complicated. Perhaps you have old 401(k) from a previous employer, and you roll that into an IRA. So now, you have pre-tax dollars in a 401(k), and you roll that over to an IRA. Then you want to do a backdoor Roth conversion, and it gets a little complicated. It’s not just your traditional IRAs that count when looking at this aggregation – it also includes SIMPLE and SEP IRAs. You have to consider all those accounts before you make a conversion to a backdoor Roth.

So, what do you do if you have money in a traditional IRA and you want to do a backdoor Roth, but you don’t want to have all that taxable income. You may be able to do a reverse rollover. If you have access to a 401(k) or 403(b) plan, you may be able to roll your IRA into your 401(k) or 403(b). Then, you can roll it into a Roth IRA.
Be careful to follow the exact rules that your plan administrator gives you for this reverse rollover. Then, you contribute to a non-deductible IRA, and then you keep that money invested for a period of time, and then you convert to a Roth IRA.

Then you have to consider the 5 year rule that we talked about last week. There is a 5 year rule that applies to a conversion Roth account, but the clock re-starts every time you convert. So if you anticipate needing this money within 5 years, you need to know that you might be paying taxes and/or penalties on the money you take out.

The backdoor Roth strategy is a powerful tool, and is probably a good idea for most investors who make too much to contribute to a Roth IRA. Some custodians will even make it relatively automatic. Do it!

Highlights of this week’s episode:

How individual circumstances might make it possible to move money into a Roth without paying taxes

The step transaction doctrine – why it matters, and should you should be worried?

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Once a month, Devin and John answer listener questions.  Send your questions to questions@bigpictureretirement.net.  They can’t answer every email or question, but they sure do try!