In previous blogs, I’ve written about the importance of tax diversification in retirement, especially if you plan to retire prior to age 60. Diversifying your assets across the three tax buckets during your accumulation years can help smooth out taxable income and give you flexibility to somewhat control your tax rate in retirement. The three tax buckets I’m referring to are:
- Tax-deferred – this would be a traditional IRA and your pre-tax contributions to your 401k or other company retirement plan
- Tax-free – this would be your Roth IRA and Roth 401k contributions where you contribute after-tax dollars but then never pay taxes again on the contributions or the growth, provided you meet a few basic rules on the timing of the withdrawals
- Taxable – this is your typical brokerage account where you invest after-tax dollars and pay capital gains taxes on any growth after you sell
For those of you with modified adjusted gross incomes (MAGI) above the Roth limits, you may think Roth IRA contributions are not an option for you. And while your 401k plan may offer the option to make Roth contributions, the tax savings on pre-tax contributions today may be too great to pass up, especially if your combined federal and state income tax rate is above 30%.
Fortunately, there is another way to get money into a Roth IRA, even if your household income is above the phaseout range. It involves a strategy known as a “Backdoor Roth IRA.” There are a number of rules and moving parts to this strategy, but if executed properly, it would allow you to make the maximum contribution to a Roth IRA each year. For a married couple under age 50, that’s $12,000 a year in Roth IRA contributions, based on 2022 contribution limits. For a couple starting this strategy at age 30 and executing every year until age 50, that’s $240k in Roth contributions. And assuming an 8% annual return, that’s over $1.2M in Roth money by age 60. THAT’S $1.2M OF TAX-FREE-FOREVER MONEY!
Disclaimer: Of course, there is no guarantee that you’ll earn 8% annually.
So, how exactly do I execute a Backdoor Roth IRA contribution?
I thought you’d never ask! Here are the steps:
- Contribute to a traditional IRA (you may have to open a new IRA to do this)
- Convert the traditional IRA to a Roth IRA
- But do NOT deduct the contribution…this is an AFTER-TAX contribution to a TRADITIONAL IRA
- Report the transactions on IRS form 8606 when you file your tax return
- This is the form where, among other things, you report nondeductible contributions to a traditional IRA and conversions from a traditional IRA to a Roth IRA
The Backdoor Roth IRA is not for everyone, but if your income is above the limits for Roth contributions, it might make sense. Here are some points to consider when deciding if this strategy is right for you:
- Household modified adjusted gross income (MAGI) should be above the Roth contribution income limits
- If you are below the limits and can make Roth IRA contributions directly, there is no need for the Backdoor Roth strategy
- You should not have any pre-tax IRA money (but keep reading if you do)
- If you have any pre-tax money in a traditional IRA, SEP IRA, SIMPLE IRA, or rollover IRA (from a previous employer’s 401k or other retirement plan), you will be hit with something known as the “pro-rata” rule when executing the Backdoor Roth IRA strategy
- The pro-rata rule as it applies to this situation means that when converting pre-tax IRA money to Roth money, you must convert a pro rata amount of pre-tax and after-tax dollars
- In a nutshell, when converting your after-tax traditional IRA contributions to Roth, you will have to proportionally convert the pre-tax IRA dollars and the after-tax IRA dollars
- For example, if you have $94k in pre-tax money in a traditional IRA and make a $6k non-deductible contribution to a traditional IRA to execute the Backdoor Roth, you then have $94k pre-tax and $6k after-tax in your IRAs for a total of $100k (it doesn’t matter that they are different IRAs…ALL of your non-Roth and non-inherited IRAs are combined for pro rata calculation purposes). When executing the conversion of the $6k you contributed for the Backdoor maneuver, you will have to convert $5,640 of pre-tax money (94k/100k = 94% * 6k = 5,640) and $360 of after-tax money (6k/100k = 6% * 6k = 360). The result would be that $5,640 of the Backdoor Roth conversion would be a taxable conversion of pre-tax dollars and the other $360 would be a non-taxable conversion of after-tax contributions. This would also leave $5,640 of after-tax contributions in a traditional IRA and severely complicate your financial life down the road.
- So, if you have any pre-tax IRA, SEP IRA, or SIMPLE IRA money, you’ll want to avoid the Backdoor Roth IRA…or:
- One strategy to consider is to roll all of your pre-tax IRA, SEP IRA, and SIMPLE IRA money into your company 401k plan in order to eliminate any pre-tax IRA dollars before executing the Backdoor Roth IRA strategy (technically, it just has to be done by 12/31 of the year you do the Backdoor Roth contribution)
- 401k, 403b, and 457 plans, along with other Roth IRAs and inherited IRAs, are not considered in the pro rata calculations
- The pro rata calculation is specific to each spouse. Provided YOU don’t have any pre-tax IRA, SEP IRA, or SIMPLE IRA dollars, YOU can do a Backdoor Roth contribution without worrying about the pro rata rule. The same applies to your spouse.
- You’ll also want to consider the costs associated with rolling IRA assets into your 401k. Employer retirement plans often have poor investment options with high fees.
If you have a Roth option in your company 401k, 403b, or 457 retirement plan AND you are NOT currently maxing out contributions to the plan, it likely makes more sense to make the Roth contributions through the company plan than to go the more complicated Backdoor Roth IRA route
The decisions around pre-tax vs Roth (and how much of each) in your 401k are very much personal and specific to your unique circumstances. You will want to consult with your CPA and a Financial Planner to determine the best strategy for your situation, and even then, there is still a bit of art involved given the assumptions and estimates that must be made.
For obvious reasons, I can’t give specific financial advice in a blog or social media post. Personal finance is just that…it’s personal and should be specific to you and your family. But here are some situations, depending on other factors, where it might make sense to think about executing a Backdoor Roth IRA contribution:
- You have no pre-tax IRA assets, you are maxing out your company retirement plan, and you have additional after-tax dollars you would like to save for retirement
- Among the many alternatives, your decision may come down to saving into a taxable brokerage account or making a Backdoor Roth contribution…or both
- In this situation, it might make sense to carve out $6k (or $12k if married and neither of you have any IRA money) for the Backdoor Roth and invest the remainder in the taxable brokerage account
- Another scenario might be that you are maxing out your company retirement account, splitting the contributions between pre-tax and Roth, and saving an additional amount into a taxable brokerage account
- In this scenario, it might make sense to:
- Increase the pre-tax 401k contributions by $6k
- Decrease the Roth 401k contributions by $6k
- Decrease the taxable brokerage contributions by $6k, and
- Do a Backdoor Roth IRA for $6k
- This would actually put more money in your pocket by increasing the pre-tax contributions, thus freeing up additional dollars to put in the taxable brokerage account
These are just some examples of the things you (or your Financial Advisor) should be thinking about. Again, none of this should be taken as specific advice. But I did want to give some examples of how the strategy could be used rather than just talking theory.
There are many other things to consider when looking at pre-tax vs Roth vs Backdoor Roth vs taxable brokerage account savings strategies. In particular, if you’re thinking about executing a Backdoor Roth IRA contribution, do your homework or speak with someone who has experience in this area. This blog does NOT contain a comprehensive list of all the rules to consider or things that can go wrong. The purpose of the blog is simply to educate you on an option that you may not have been aware of.
