Backdoor IRAs Circumvent Roth Income Thresholds

Don’t see an option for a backdoor IRA? That’s because there is no such account. “Backdoor IRA” is a process for wealthier people to circumvent income limits that make them ineligible for a Roth IRA.  Yes, it’s legal.

It’s called a backdoor because high earners are not allowed to come in the same way as everyone else. In 2021, any individual with an Adjusted Gross Income of $140,000 and up is not allowed to open a Roth IRA. Married couples filing jointly cannot have an AGI higher than $208,000 for the tax year 2021. There are no income limits on a traditional IRA.

So why are high earners trying to find a backdoor? Because eligible withdrawals are tax-free.

Benefits of a Roth IRA

A Roth IRA differs from a traditional IRA in one major way. Contributions to a Roth IRA are funded with after-tax dollars. You can’t deduct them from your income like a traditional IRA, which is funded with pre-tax dollars.

Both have the same limits on annual contributions – $6,000 a year. Unless you’re over 50, then it’s $7000. You have to be 59 1/2 to withdraw money from a traditional IRA. Not so for the Roth IRA, but the account has to be open for 5 years.

When you withdraw money from the Roth IRA – it’s tax-free. If you started your Roth IRA at 30 and put in the maximum until you hit 50,000 – that’s $120,000+ interest.  If you add another 10 years at $7,000, by the time you reach 60, your account has $190,000 plus interest. (Which is typically forecast at 7%.)

You can pull it out for any reason. Buy a business, get a second home, put your grandchild through college. You paid your taxes along the way, so the cumulative value of your account is tax-free.

Not the same for a traditional IRA. Withdrawals are taxed as income, at your current tax bracket. For smaller withdrawals that may not be an issue. But if you want to pull a substantial sum, it’s going to cost you.

(Is it Smart to Put my 401k in an IRA?)

How Does a Backdoor IRA Work?

It’s pretty simple, but you need to do it right. Let’s say you make around $250,000 a year. You can’t have a Roth IRA because you’re over the income limit. But you want one. You get around the income limit by going through a back door.

You create or convert an existing IRA to a Roth IRA. Account-holders are entitled to one Roth conversion per year.

Convert Your Existing IRA

  1. Make a contribution to your existing IRA. There are no income limitations for traditional IRAs.
  2. Roll some or all of the money from your IRA into a new Roth account. Your financial administrator manages the conversion which includes setting up the Roth IRA. You can transfer as much money as you want. The limit for annual contributions does not apply in this transaction.

3. Be prepared for the taxes. The money you convert is now income. Depending on the transfer amount and the tax bracket, the tax liability can be significant. Note that the increase in your income can be an issue. If you transfer too much, you may find yourself pushed into a higher tax bracket. Some investors spread out the transfer to minimize tax liability in any given year.

  1. Taxes also apply to any investment gains that the IRA has accrued. Ideally, they are pre-tax contributions. Make sure you discuss these issues with your financial adviser. Investors need to understand exactly what the outlay will be.

IRS Pro-rata Rule

The term pro-rata is from the Latin, meaning “in proportion.” In practice, it means that a person will pay or receive an amount relative to their share of the whole.  Dividend payments are determined pro-rata, so are insurance premiums.  The IRS applies the pro-rata rule to tax backdoor IRA conversions.

The pro-rata rule applies if you have both pre-tax and after-tax contributions in your accounts. The IRS considers the whole to be the sum of all IRA accounts you hold. That includes SIMPLE IRAs and SEP accounts. It does not include Roth IRAs or inherited IRAs.

Traditional IRAs are pre-tax dollars. But some IRA contributions can be non-deductible, making them taxable on conversion. Your tax is decided by determining the percentage of pre-tax dollars. If 60% of your total IRAs are pre-tax and 40% after-tax – you pay 60% on the conversion.

The pro-rata rule is calculated at the end of the tax year, not at the time of the conversion.

The Workaround

If you have a traditional 401, check to see if it can be transferred to a traditional IRA. If it can, you may be able to do a reverse transfer. If yes, you can reduce or eliminate the total amount in IRAs. You just transfer the money to the 401k. Taxes are deferred. It’s legal and if you are subject to pro-rata, it’s a solution to minimize your tax liability.

If you can’t transfer your IRAs to your 401k, there is another option. You can transfer some of your IRAs to an annuity. Like IRAs, annuities are tax-deferred. Some company’s offer a bonus annuity to attract business, offering a cash bonus between 2 and 10 percent. The bonus money may cover the taxes on any pro-rata transfers.

More Rules to Follow

When making the transfer of funds, there are rules to follow.  The funds from your conversion need to go directly to the Roth IRA. Here’s how to manage the transfer.

The trustee of your IRA account sends the money directly to the trustee of the Roth IRA. A same-trustee-transfer handles the rollover between accounts in the same financial institution. (It makes sense to work with your current provider when possible.)

If you rollover the money yourself, you have 60 days to transfer the funds.  This method is the least desirable.

(Is a Roth 401k Better than Your Traditional 401k?)

What if You Already Have a Roth IRA?

If you started a Roth IRA before you hit the income threshold, you can do the conversion without creating a new account. The amount an investor can contribute to a Roth IRA diminishes as income grows. Once you hit the limit, contributions aren’t allowed.

But it can still serve as a vehicle for a backdoor conversion. As along the account exists, it overcomes the 5-year rule for governing Roth accounts. Once you pay the taxes from the previous IRA, you can withdraw at will. No age limits, no taxes.

Backdoor a 401K to a Roth IRA

Can you convert a traditional 401k to a Roth IRA? Yes, you can. But some issues complicate the process.

Check the rules on your employer’s 401k plan. Some rollovers or conversions are limited to certain types of accounts. If you can’t do a direct Roth conversion, most plans let you move your 401k to a traditional IRA. Then you could backdoor that account to a Roth account.

If you can convert to a Roth, you need to decide if you’re going to do all it at once. Here’s the issue. Most employers won’t let you can’t take part of the 401k and leave the rest behind. But some will let you split the transfer to multiple accounts.

You still have to pay taxes on the amount you roll over to the Roth IRA. If you break it up, any money transferred to a traditional IRA is not taxed until you withdraw it.

No Pro-Rata Rule

The pro-rata rule doesn’t apply to 401k conversions. But you can end up pushing yourself into a higher tax bracket, depending on how much you transfer.

If you split the amount with a traditional IRA, it may affect future conversions. If they fall under the pro-rata rule, it’s included in the sum total of your IRA contributions.

When you plan a conversion, backdoor or otherwise, be strategic in the amount and timing of the transfer.

How Does a Mega Backdoor Roth Works

100 dollar bills flying everywhere

A mega backdoor Roth requires a 401K. For the 2020 tax year, this practice lets investors exceed the annual contribution limit by up to $37,500. There are specific parameters to meet to conduct the conversion.

  1. Your plan needs to allow “after-tax” contributions. After-tax contributions fall in a separate bucket. (They are not the same as structured Roth after-tax contributions.) Either your employer plan offers them, or they don’t.
  • In 2020, the maximum you and your employer can put into a 401k is $57,000. If you’re over 50, it jumps to $63,000.
  • Total up your annual donations and subtract them from the maximum amount. That’s the amount you could put it with a mega backdoor Roth. If you’re over 50 and have $30,000 in your account, you could put in $25,500.
  1. Your employer plan allows you to distribute money from your 401k to a Roth IRA while you’re still employed. Or they will let you move the after-tax portion of your plan to a Roth 401k. The goal of mega backdoor is to get all your after-tax money into an after-tax plan.
  • If your employer doesn’t offer in-service distributions, you can’t complete the conversion until you leave your job. The tax code changes regularly – what works in 2020 may not work in 2024.

 To leverage the mega backdoor Roth, you need to have the money to invest. If not, you can open a Roth IRA and/or Roth 401 to start.

Is a Backdoor Conversion Right for me?

A backdoor IRA conversion is designed to benefit wealthy people. They have professionals to manage their money. They follow a financial strategy and rely on advisors to help them make the best decisions. They also have the assets to cover any tax liability or contribute to a mega backdoor.

If that’s not you, you may want to think twice about it.

Other red flags include the tax liability. If you can’t pay the taxes without pulling them from the retirement account, it’s a long term loss. The taxes on the transfer are considered income and can push you into a higher tax bracket. Lastly, if the Roth account is created during the conversion, you can’t withdraw money for five years. At least without a 10% penalty.

Understanding a Backdoor IRA

To put it simply, if you have the money to do a backdoor IRA, you probably wouldn’t be reading this article.  You’d be following the advice of your broker or financial advisor.

Here’s a quick summary of key points:

  • A backdoor IRA is a legal workaround to get a Roth IRA when your income level is too high to open one.
  • The process lets you transfer contributions from a traditional IRA into a Roth IRA. You have to pay income tax on the money you transfer.
  • Be careful not to push yourself into a higher tax bracket – the transfer amount is considered income.
  • The pro-rata rule applies if you have a mix of pre-tax and after-tax contributions in the source accounts. The rule looks at the total of all your IRAs to find the percentage of pre-tax dollars. That percentage is what you will pay tax on during the conversion.
  • Once the conversion is complete, the Roth account must remain open for 5 years before you make a withdrawal. Otherwise, you pay a 10% penalty.
  • A Mega Backdoor is a way to add money to a 401k above and beyond the normal contribution limits. Your employer’s plan must allow after-tax contributions. The plan also needs to offer in-service distributions to a Roth IRA or Roth 401k.
  • If you do not have the capital to cover the tax liability, this is probably not the best option for you. The same goes for the mega backdoor conversion.

 

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