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Backdoor Roth IRA Contributions

Roth IRA earnings grow tax free and distributions from Roth accounts are also generally tax free (as long as you’re 59 ½ and have had the account at least 5 years). Unlike traditional IRAs, there are no required minimum distributions from your Roth IRA in your lifetime. In retirement Roth IRAs can help you balance your taxable vs nontaxable distributions and give you more flexibility in tax planning. Because most people have the majority of their retirement assets tied up in tax deferred accounts such as 401Ks and traditional IRAs, adding money into a Roth IRA is desirable for many high earners and high net worth individuals.

However, getting money into a Roth IRA can be difficult. Roth IRA contributions are not allowed for married couples earning over $208K or individuals earning over $140K. That’s where the backdoor Roth IRA contribution strategy can come into play. 

How a Backdoor Roth IRA Contribution Works:

  • Make a non-deductible contribution to a traditional IRA (contribution limit for 2021 is $6K and for those over 50 it is $7K). 
    • File IRS form 8606 
  • Transfer the assets contributed to the traditional IRA into a Roth IRA

There is no income limit on making a non-deductible IRA contribution. By converting the non-deductible IRA into a Roth account, this strategy allows those not normally able to contribute to a Roth to get money into that account. 

But there’s a catch….

Pro Rata Rule

The IRS has an IRA Aggregation Rule which stipulates that the value of all IRA accounts will be aggregated for the purpose of any tax calculations. Thus, if you have a traditional IRA, a non-deductible IRA, a SEP IRA, etc, the IRS will consider the aggregate value of all the accounts together when you try to do a Roth conversion. Note that employer sponsored retirement plans such as 401Ks and 403Bs do not count toward the IRA aggregation. 

Under the pro rata rule, you will pay tax on a conversion equal to the taxable percentage of your IRA accounts in aggregate. For example, if you have a $94K traditional IRA and make a $6K non-deductible IRA contribution, then you will have an aggregate IRA value of $100K. 94% of your aggregated IRA balance is tax deferred while only 6% is made up of the non-deductible contribution. If you convert $6K into a Roth IRA, you will have to pay taxes on 94% of that conversion. Thus only $360 of your contribution will be excluded from income. 

For some, there is a way around the pro rata rule. As I mentioned before, 401Ks do not count toward your IRA Aggregation that the pro rata rule is based on. Some employer sponsored retirement plans allow for roll-in contributions from existing IRA accounts. If your employer sponsors such a plan you could roll all your existing IRA accounts into your employer sponsored plan so that there will be no remaining tax deductible IRA balances. Then in the future 100% of non-deductible IRA contributions can be rolled over to a Roth IRA without paying taxes on the conversion. The main problem with this strategy is that most employer sponsored plans have higher fees and vastly fewer investment options than an IRA account. Additionally, many plans do not allow for roll in contributions. 

The following infographic from Odsonfinance illustrates this backdoor process:

Mega Backdoor Roth IRA Contribution:

This is a strategy for those who have already maxed out their 401K and IRA contributions. It’s only available to those whose employer sponsored retirement plans allow them to make after tax contributions and to make in-service withdrawals. In 2021, the maximum allowable contributions to employer sponsored plans between your contributions and your employer is $58,000 (or $64,500 for those over 50). 

The Mega Backdoor Roth IRA Contribution is a strategy in which you contribute after tax dollars into a 401K plan up to the difference between your maximum annual contribution limit and the amount you and your employer contributed for the year. For instance, say you and your employer saved a total of $25K into your 401K plan for the year. That means you have an additional $33K available to reach the $58K limit. With the mega backdoor strategy you would make an after tax contribution of up to $33K and then immediately take an in-service withdrawal of that contribution and transfer it into your Roth IRA. 

Scott Caufield, CFA, CPA