How Does a Backdoor Roth IRA Contribution Work?

Backdoor Roth IRA contributions are a commonly used planning technique to help high-income earners contribute to a Roth IRA, even when their income is higher than the maximum set by the IRS. While the strategy is commonplace, the logistics are often misunderstood. This can lead to misconceptions and potential errors on tax return filings. In this article, we discuss the income limitations for direct Roth IRA contributions and the tax deductibility limitations for Traditional IRA contributions.

Contribution Limits to Individual Retirement Accounts (IRAs)

For 2021 and 2022, you can contribute up to the lesser of $6,000 ($7,000 if you are 50 years of age or older) or 100% of your earned income to a Traditional or Roth IRA.  The total amount you can contribute to all IRAs is $6,000.  You may also be eligible to contribute up to $6,000 to an IRA in your spouse’s name even if he or she receives little or no earned income.  Contributions need to be made by the tax filing deadline of April 15th (note: tax extensions do not extend IRA contribution deadlines).

Roth IRA Versus Traditional IRA

As advisors, we are always excited about the opportunity to help clients contribute to Roth IRAs. Roth IRAs have several unique features that make them appealing; the main feature being tax-free growth. The table below summarizes the main differences between Roth and Traditional IRAs.

Roth Income Limitations and Traditional IRA Deductibility

Due to income limitations placed on Roth IRAs, it is challenging for high-income earners to directly contribute funds to a Roth IRA. For example, if you are Married Filing Jointly (MFJ) and your Modified Adjusted Gross Income (MAGI) exceeds $208,000 you are not allowed to directly contribute to a Roth IRA.

Additionally, Traditional IRAs have income limitations for tax deductibility. For example, if you are Married Filing Jointly (MFJ) and your Modified Adjusted Gross Income (MAGI) exceeds $125,000, you are not allowed to take a tax-deduction for your contribution.

Solutions if Your Income is Over These Thresholds

The complexity of Roth IRA income limitations and Traditional IRA deductibility brings us to the concept of the backdoor Roth IRA contribution.  The IRS currently allows high income earners to make an IRA contribution, then subsequently convert that contribution to a Roth IRA.

Step One – Make a non-deductible IRA contribution.  The contribution is not deductible for income tax purposes, but it is reported on your tax return on Form 8606.  The contribution is made with funds that taxes have already been paid on and these “after-tax” dollars creates basis in the IRA account.  The Form 8606 is an information schedule included in your return that keeps track of all the “after-tax contributions” you’ve made over time.

Step Two – Roll the non-deductible IRA contribution into a Roth IRA.  If you have no traditional IRA balances before making the backdoor Roth IRA contribution, you will have no income tax consequences (assuming there are no earnings on the non-deductible IRA contribution before the rollover to the Roth IRA).  There is no income tax since you have basis in the IRA equal to your non-deductible contributions.

However, if you have large Traditional IRA balances, the backdoor Roth IRA contribution may have unintended income tax ramifications.

Be Careful of The Pro-Rata Rule

The key reason the backdoor Roth IRA contribution works without creating a tax liability is because there are no pre-tax dollars already held in the Traditional IRA. The IRS requires that a conversion from a Traditional IRA to a Roth IRA be done on a pro-rata basis.

What this means:  When determining the tax liability on a conversion, the IRS looks at all of your Traditional, SIMPLE, and SEP IRA accounts combined.  For example, if your accounts consist of 80% pre-tax dollars and 20% after-tax dollars, then that ratio determines what percentage of the money you convert to a Roth is deemed taxable. In this example, 80% of the conversion amount would be taxable.

Unfortunately, you cannot choose to convert only after-tax money. The IRS applies the pro-rata rule to your total IRA balance at year-end, not at the time of conversion. It is worth noting that 401(k)s, even self-employed 401(k)s, and IRAs you may have inherited from someone else, are not included in the pro-rata calculation.

See below for a high-level illustration of how the taxable conversion amount results in $0 tax due.

If you would like to explore whether a backdoor Roth IRA contribution is right for you, please reach out to your Coldstream team. We will work closely with you and your tax advisor to make sure it makes sense for your situation and you have the proper documentation to report your backdoor Roth IRA contribution.

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