How Does A Backdoor Roth IRA Work?

We have already written about the differences between a Traditional IRA and a Roth IRA in our recent article on Roth IRA Conversions here. Roth IRAs allow you to take after tax monies and grow them tax free for retirement.

However, as we saw, there are limitations to a Roth. For one, if you earn over a certain amount (see below), you are no longer eligible to open a Roth IRA account.

Remember That The Backdoor Is Open

You can make a non-deductible contribution to a traditional IRA. Then you immediately convert it to a ROTH IRA.

But there are ways around this limitation and this is where a Backdoor Roth comes into play. Basically, the idea is to open a Traditional nondeductible IRA and then convert it to a Roth.

The steps to a Backdoor IRA are simple:

1) Contribute to a non-deductible Traditional IRA.
2) Convert that account to a Roth IRA.
3) Pay taxes on the gains while the assets were in the Traditional IRA before conversion. 
4) Repeat next year.

Again, all things being equal, after the conversion, the only taxes that would be due would be on the appreciation of the converted assets in the Traditional IRA account. If it's done right away his or her taxable liability should be little to nothing, especially if the assets are left as cash while in the Traditional IRA account.

In theory, a married couple making $400,000 and contributing the maximum to their 401(k)s, but that do not have IRAs, can each create Traditional IRAs, fund them with $5,500 each ($6,500 if they're over 50), and then immediately convert both accounts to Roth IRAs. If they do this for the next 10 years, they will have a total of $110,000 plus any appreciation in a tax free account for retirement.

What Can Possibly Go Wrong?

The one main thing to note in this strategy is the fact that this couple did not have an existing IRA. If you already have a Traditional IRA, the taxable portion is prorated over all existing IRAs. You cannot just select the non-deductible account or contribution. This is referred to as the IRS Aggregation Rule.

For example, if you have a non-deductible Traditional IRA account with $10,000 with the goal of backdoor converting it to a Roth IRA, but already have a deductible Traditional IRA account (perhaps a rollover from a 401(k)) with a balance of $20,000, you would have to divide the $10,000 by $30,000 (the total balance of both IRAs) and get the percentage of the conversion that will be tax free. In our example, only 33% would be tax free.

Workaround #1

This too has a possible workaround. You can avoid the Aggregation Rule by the fact that employer plans such as 401(k)s and Profit Sharing Plans are not included in the rule. Keep in mind, however that Simple IRAs and SEP IRAs are included in the rule.

Therefore, if the 401(k)s the couple in our example have allow for a "roll in," the ability to roll outside assets in Traditional IRAs into the 401(k), they could transfer the Traditional IRA with $20,000 into the 401(k) leaving just the non-deductible account of $10,000 exposed to the IRA Aggregation Rule, which could then be converted 100% tax free (assuming no appreciation in the assets). This obviously wouldn't work for everyone, especially those without employer 401(k) plans that allow roll ins.

Workaround #2

If the investor does not have an employer 401(k) plan and in fact is self employed - such as a consultant - they could set up an Individual 401(k) plan. Once the account is established (obviously with an administrator that accepts roll-ins) and the investor is making regular contributions, they could then roll in their deductible Traditional IRA (the $20,000 in our example), convert the remaining non-deductible Traditional IRA assets (the $10,000), and call it a day.

Also, as noted earlier, this must be done serially to be beneficial. For individuals or couples with high net worth, $11,000 or $13,000 a year may be just a drop in the bucket. However, if this is done early enough and consistently enough during the accumulation phase of the investor's life, they will have moved a considerable amount of their assets into the Roth account to grow tax free as well as avoid required minimum distributions at 70 1/2 years of age.

Washington D.C.

Remember, this strategy only came into effect in 2010 when the IRS changed a rule lifting the limits that were imposed on converting Traditional IRAs to a Roth. As we all know, these rules may change at any time. If in the future congress acts and removes either the tax free benefit or the lack of RMD's portion of a Roth IRA's character, then a Backdoor IRA conversion may turn out to be the wrong move. Only time will tell.