A ‘backdoor’ Roth is a way for individuals to contribute to a Roth IRA, when their income is over the Roth IRA eligibility limits.
High-income individuals who are covered with an employer retirement plan, such as a 401k, are likely not eligible to make a tax-deductible (pre-tax) contribution to a traditional IRA. However, there is no income limitation if the person wants to make a non-deductible (post tax) contribution and then use the so-called “back door” to convert the contribution to a Roth IRA.
Any after-tax contributions to a Traditional IRA are not taxed when converted to a Roth IRA (because they have already been taxed). However, any pre-tax contributions and any growth within the Traditional IRA is taxed as normal income when converted.
In its simplest form, a “back door Roth” is where a person makes an after-tax contribution to a traditional IRA and then, in very short order, converts the traditional IRA to a Roth. The only tax due would be if there is any gain realized between the time the Traditional IRA contribution was made and when the conversion to the Roth IRA occurred. The strategy is complicated if the individual has an existing Traditional IRA containing any pre-tax contributions or any investment gains. The detailed steps to complete a ‘back door’ Roth are described in the next section.
Note: IRAs are owned by an individual only. Therefore, when an IRA is referenced in the steps below, it is the context of each individual’s IRA accounts. This includes traditional IRA, SEP-IRA or SIMPLE IRA accounts.
Step 1 – Determine eligibility for a Roth IRA
If your joint modified adjusted gross income (MAGI) is less than $184,000 (joint), $117,000 (single) (2016) , you are eligible to freely contribute to the Roth IRA and the subsequent steps are unnecessary.
The maximum allowable contribution to a Roth IRA is phased out for individuals with a joint MAGI between $184,000 – $194,000 (Married, filing joint ), $117,000 – $132,000 (Single) (2016). You should consult the IRS tables to determine the specific amount.
Individuals with joint MAGI income above the $184,000 (joint), $117,000 (single) cannot directly contribution to a Roth and can use the remaining steps below to make the ‘backdoor’ contribution to a Roth IRA.
Step 2 – Inventory current IRA holdings
Determine the total pre-tax contribution, after-tax contribution and investment growth for all your traditional IRA, rollover IRA, SEP-IRA and/or SIMPLE IRA accounts.
If you rolled over a previous employer’s 401k, 403b or similar program into an IRA, then the entire amount that is considered a pre-tax contribution. SEP and SIMPLE contributions are also classified as pre-tax.
If you have a traditional IRA with a mix of pre-tax and after-tax contributions you need to determine how much is pre-tax and after tax. This information can be found on the Form 8606 that were submitted with your previous year’s taxes.
Step 3- Continue the tax deferral
Whenever any portion pre-tax and growth is withdrawn from an IRA, then it is subject to tax. That applies if is for an ordinary withdrawal or for Roth conversion.
One options to remove the pre-tax money from the IRA and to maintain the tax deferral status is to rollover the funds into your employer’s sponsored 401k, 403b or 457 retirement program. You should verify with your employer if your plan allows a rollover into the plan.
If you are self-employed, then consider opening an individual 401k (also known as solo 401k) and rolling the IRA into this account. There are restrictions on who can open a solo 401k and some custodians do not allow rollovers into the solo-401k.
Before taking this step, there are some caveats to consider:
- Verify your employer’s plans offer the rollover into their plan.
- Consider the investment options in the employer’s plan. Are there sufficient investment choices to use when building a diversified portfolio? Are you limited to expensive, inflexible products such as variable annuities (common in 403b plans)?
- Are there high management fees and/or investment fees associated with the employer’s plan?
- You may have investments in the IRA that you do not want to liquidate or sell. Check with the 401k provider, as it may be possible to do an ‘in-kind’ transfer of the investment into the 401k.
These are tradeoffs to consider within the context of the overall financial plan and may be a deterrent to completing the Roth conversion. If your 401k plan does not support rollovers or you deem it unsatisfactory, you can still do a conversion and pay the tax, as explained in the discussion about pro-rata tax below.
Step 4 –Contribution to the traditional IRA and convert to Roth
Make a new contribution into the traditional IRA account. You can contribute up to $5500 ($6500 if age 50 or older) (2016) into the account. Then instruct your IRA custodian to convert the traditional IRA to a Roth IRA. You can convert a any portion, up to 100%, of the new contributions and the after-tax contribution designated in Step 2 to a Roth IRA.
The IRS does not specify any wait-time is required between the depositing the funds into the traditional IRA and converting it to a Roth. Ensure you keep all records, showing date and times of transactions should the IRS ever question the transaction.
If there happens to be a gain in value from when the funds are deposited and the conversion to the Roth, or if there is any pre-tax funds converted, you will need to pay taxes on that amount.
Step 5 – Establish your asset allocation
Purchase the investments within the 401k and the Roth account to fill out your asset allocation as defined below.
If you are unable, or do not want to use step 3 above you can still use the back door conversion to contribute to a Roth IRA, albeit you will be required to pay some taxes on the conversion.
Looking back at Figure 1, your total IRA holding could have a mix of pre-tax and after-tax money. When you roll over money to the Roth IRA, the amount converted from each type of account is proportional to total mix. This is best explained as an example.
Assume there is a total of $100,000 in the IRA, where 90%, or $90k, is from pre-tax contributions and gains. The remaining $10k, or 10%, is from after-tax contributions. Then, if you want to convert $10,000 of the IRA into a Roth, then the IRS assumes $9000 (or 90%) is coming from the pre-tax side and only $1000 (or 10%) is coming from the after-tax side. Thus, because you must pay the tax on pre-tax money when it is converted, you will owe tax at your regular income tax rate on $9000.
This rule applies to new after-tax money you contribute the traditional IRA, where you are intending to do a back door conversion. The new money will be included in the proportional calculation on how much tax will be due from the conversion.
 Roth IRA income limits: $117,000 – $132,000 Single; $184,000 – $194,000 Married, filing joint (2016)
 SEP and SIMPLE IRAs are included in the category of Traditional IRA.