Have you ever heard the term “Backdoor Roth” before? Sounds mysterious, maybe even a little sketchy right? Every year it comes up in an article in any number of financial publications like Forbes or Morningstar and is often portrayed to be some super-secret new idea for high income savers. It is not a special type of account (it is a conversion technique). It is not mysterious, sketchy, or illegal (as we’ll show via the IRS code and reports from Congress). It is not new (it has been in use since 2010).
We wanted to outline this technique in three parts that should help explain how it came about, the steps needed to complete it, and the follow-up work necessary to stay out of trouble with the IRS. This should stand as a guide for 2021 and beyond, or at least until they change the tax code once again!
Where did the Backdoor Roth come from?
To answer where the Backdoor Roth came from, we need to start at the beginning. The creation of the Roth IRA itself. The Roth IRA was formed as part of the “Taxpayer Relief Act of 1997”. This allowed for a new type of account that could grow after tax contributions tax deferred and generally distribute the proceeds tax free, provided a few rules were followed. They shared some of the same regulations with Traditional IRAs such as the amount you can contribute and income limitations on making contributions or converting Traditional IRA dollars to a ROTH IRA.
What that meant was individuals, or families, earning over a certain amount were excluded from making deductible IRA contributions (remember the deductible part as that will be important later) and all Roth IRA contributions. For example, in 2021 the limits on direct Roth IRA contributions are Modified Adjusted Gross Incomes (MAGI) over $140,000 for individuals and $208,000 for married filing jointly (MFJ) taxpayers. There is also a reduced contribution limit that comes in phases starting at $125,000 for individuals and $198,000 for MFJ. To make things more complicated MAGI is NOT a number that appears on your tax return and needs to be calculated independently. If you aren’t sure if this applies to you follow the link above for more details or consult with your advisor or tax preparer.
Now, back to the story. Another grand sounding law called the “Tax Increase Prevention and Reconciliation Act of 2005”, passed in 2006, repealed the income limitation on converting IRA dollars to a Roth IRA starting in 2010. Anyone over the MAGI threshold still couldn’t contribute directly to a Roth IRA, but now they had another opening to fund a Roth IRA. The problem was that if you were in a really high tax bracket converting your IRA to a Roth IRA would incur immediate taxes that you didn’t want. In addition, you may have been saving in a taxable account because you maxed out all your other pre-tax options and contributing to an IRA without getting a tax deduction didn’t seem worth it. That now changed once Roth conversions were allowed. High income earners could make nondeductible IRA contributions still, and for the first time had the ability to convert them to a Roth IRA. This is how the Backdoor Roth IRA conversion was born.
Initially it was deemed a loophole that many believed would eventually be closed by Congress. Instead, it has grown in popularity within government. Nationally renowned estate planning expert Natalie Choate described it this way. “Any doubts about the legality of the backdoor Roth contribution went away once the Joint Committee on Taxation, in its report on the Tax Cuts and Jobs Act of 2017, favorably mentioned this approach four times in its “Joint Explanatory Statement of the Committee of Conference. In 2020, the maneuver became legal even for individuals over age 70 1/2 (prior to that year they were barred from making traditional IRA contributions).” It appears that the Backdoor Roth conversion is here to stay.
How do you do a Backdoor Roth IRA Conversion?
The steps to complete a Backdoor Roth IRA conversion (some people call it a contribution but that is just semantics) is actually pretty simple. The harder part is making sure you have checked all the appropriate details, which we will describe with each step.
Step #1 – Calculate your MAGI (or have someone else do it):
There is no reason to go through all this hassle if you can contribute to a Roth IRA directly, so check this first. Sometimes it isn’t easy to tell if you have fluctuating income from year to year or a lot of deductions that would get added back into the calculation. If you are certain you will be above the 2021 thresholds referenced earlier then proceed, but with caution.
Step #2 – Open a Traditional IRA account:
The reason why this step says open an account, and not fund an existing account, is because if you already have a traditional IRA with a balance you need to take a step back before continuing. When you proceed with a Roth IRA conversion the IRS applies this little term called Aggregation Rules. That means it views all your IRA funds as one big pool, even if they are in separate accounts. Example: You have $95,000 in an existing IRA and make an additional $5,000 nondeductible contribution to that, or any other IRA. When you try to convert that $5,000 nondeductible contribution to a Roth IRA tax free the IRS will say “no, no, no” only $5,000 of your $100,000 total (5%) has been taxed so only 5% can be converted tax free. This is known as the Pro-rata Rule. You have now moved $250 tax free to your Roth IRA but generated an additional $4,750 of taxable income at your considerably high tax bracket.
The whole advantage of doing this is to get funds into a Roth IRA WITHOUT incurring additional taxes. So, what’s the solution? Thankfully, most employer sponsored retirement plans (think 401k) will allow you to roll your pre-tax IRA balances into them. This will allow you to eliminate any existing IRAs prior to attempting a Backdoor Roth conversion. The rules state that the total pre-tax IRA balances across all accounts must be $0 by 12/31 of that year to make a Backdoor Roth conversion a non-taxable event. Technically the order you do it in doesn’t matter, however, financial transactions don’t always go as planned so it may be prudent to roll your IRA balances into a 401(k) PRIOR to making your nondeductible contribution and moving forward. It also never hurts to have a monthly statement showing a zero balance for your records.
Two final details to remember. First, an IRA is tied to one individual, not a household. One spouse can still have IRA balances and it won’t impact the other’s ability to execute this correctly even if you file taxes jointly. Second, SIMPLE IRA and SEP IRA accounts are included in this so make sure that they are not overlooked.
Assuming you made it this far, and have your pre-tax IRA balances to $0, go ahead and make your desired nondeductible contribution to your IRA. Now you are ready for the final step.
Step #3 – Open a Roth IRA and convert your contribution:
You can set up a Roth IRA using the exact same form you used to set up the traditional IRA at most institutions. In fact, you can open both accounts at the same time, we just listed it now since it follows the logical order of things.
Next comes the funding of your Roth IRA with your nondeductible (also called after tax) contribution. This final step will require a special Roth conversion form from your custodian and both the sending and receiving account numbers. The simplest way to handle this is to keep your original contribution in cash and not invest it. That allows you to complete the conversion with the same amount and all your numbers will match perfectly.
When this technique was first being used some advisors were recommending waiting a few months, or even a year, to complete the conversion. They feared the IRS would use the “step transaction doctrine” to make the process invalid. That was when someone completed a series of separate legal steps which in aggregate allowed them to avoid a tax law, so the IRS would deem them one single integrated transaction. In this case it would be to make a Roth IRA contribution despite being over the income limit. Investors who didn’t want to be out of the market for that long invested the money while they waited, causing the gain to be taxable upon conversion and the paper trail to be a bit more complicated. The timing on when you complete the conversion step is still not fully settled. While most advisors no longer believe waiting is necessary, the favorable mention of the strategy as a whole by the Joint Committee on Taxation did not include any specifics on the timing.
Now you have successfully completed a Backdoor Roth IRA conversion. The third part of this guide is to complete the documentation so that it gets reported correctly on your taxes and anyone who reviews your tax returns down the line, like an IRS auditor, can clearly see the steps you have taken.
The Follow-up Work to Document your Backdoor Roth conversion
When you want to document a Backdoor Roth conversion there are a few things to include. Some are recommended and others are required.
The recommended pieces are simple. Keep a copy of the first monthly statement after rolling any existing IRA assets into your workplace retirement plan. Also keep a copy of the year end statement for any IRAs so you can show the pre-tax balance was zero. Keep confirmations of transactions between your IRA and Roth IRA to show the clear path of the money. Finally, keep a monthly, or transaction, statement that shows the funds arriving in the Roth IRA. Think of this as creating a snapshot of the process at each junction so that if the amount or date is ever questioned you have it covered.
The required piece is what trips up most investors. When you complete a Backdoor Roth conversion you MUST report it on form 8606. If you have ever tried a Backdoor Roth conversion yourself and don’t know what form 8606 is, that is a problem.
Form 8606 is used to report several financial transactions but the two from the IRS instruction guide we are concerned about here are as follows:
- You made nondeductible contributions to a traditional IRA for 2020
- You converted an amount from a traditional, SEP, or SIMPLE IRA to a Roth IRA in 2020
As you can see both items are key steps you will have taken and need to be reported. Specifically, form 8606 is filed with your 2020 personal tax return (1040, 1040-SR, or 1040-NR). Unfortunately, you don’t get points for effort, so let’s review how to do it correctly and avoid paying for do-overs. Despite the tips below it is still advisable to consult a tax professional. That is because there can be variations to filling out this form (we’ll mention several in the descriptions below) that might trip you up.
Part I of form 8606
Line 1: Enter the nondeductible contribution you made to a traditional IRA in 2020. The max in 2020 was $6,000 so let’s assume that for the rest of this example.
Line 2: Enter your total basis in Traditional IRAs. This will probably be $0. If you have existing nondeductible contributions that you haven’t converted before you will need to find that number from previous 8606 forms.
Line 3: Add lines 1 & 2 so you would enter $6,000 (or whatever amount you used for your nondeductible contribution).
Line 4: Enter nondeductible contributions made from January 1, 2021 through April 15, 2021. In our example this is zero as we made our nondeductible contribution, and completed the Backdoor Roth conversion, both in 2020.
Line 5: Subtract line 4 from line 3. Again, using our example this will be $6,000.
Line 6: Enter the value of all your IRAs as of December 31, 2020. If you already double checked for Traditional IRAs, SIMPLE IRAs, & SEPs (and rolled them into a 401(k) if necessary…right?) you can put a $0 here.
Line 7: Enter distributions from IRAs in 2020. This is probably $0 unless you took a withdrawal. Also be careful NOT to include things like one-time distributions to fund an HSA or a previous year’s Roth conversion.
Line 8: Enter the net amount you are converting to a Roth IRA for 2020. Again, using our example this will be the full amount of $6,000.
Line 9: Add lines 6, 7, & 8. Once again, $6,000 for our example.
Line 10: Divide line 5 by line 9 (6,000 / 6,000) giving you 1.00.
Line 11: Multiply line 8 by line 10 (6,000 x 1.00) giving you 6,000.
Line 12: Multiply line 7 by line 10 (0 x 1.00) giving you 0.
Line 13: Add lines 11 and 12 to find the nontaxable portion of all your distributions. This will be $6,000, because why would you be going through all this trouble if it would end up taxed right?
Line 14: Subtract line 13 from line 3 to find your total basis for IRAs in 2020 and earlier. This results in a 0 (6,000 – 6,000) in our example.
Line 15a: Subtract line 12 from line 7 (0 – 0) which is another 0.
Line 15b: Enter amounts attributed to a qualified disaster distribution from 2020. In our basic example this will also be 0.
Line 15c: Subtract line 15b from line 15a. This is your taxable amount for the distribution from your Traditional IRA that will need to be entered on your 1040 on line 4b. If you have done everything correctly this will be $0. If you come up with another number, then either you had a traditional IRA balance at the end of the year or another complicating circumstance that should be reviewed by a tax professional.
Part II of form 8606
Line 16: If you completed Part I (which we did) enter the amount from line 8. Remember this is the total amount we are converting. Our example lists $6,000.
Line 17: If you completed Part I (which we did) enter the amount from line 11. Remember this is the nontaxable portion we are converting. Our example lists $6,000, which matches the amount on line 16.
Line 18: Subtract line 17 from line 18 to get the taxable amount attributed to your conversion. You should get a 0 here which you are again instructed to enter on line 4b or your tax return.
You may notice that you are basically doing part of the form twice. That isn’t an error, it is just the way the IRS works and if you had answered questions differently it might matter. Fortunately for us it is just a small inconvenience that gives you one more opportunity to check your work. We won’t cover Part III since Roth IRA distributions aren’t part of this process. Just remember to keep copies of any 8606 forms you file along with your tax return.
Backdoor Roth Recap
If you decided to make the nondeductible contribution for 2020 and 2021 early in 2021 (since you can make a prior years IRA contribution up until tax filing), and convert both later in 2021, your form 8606 this year will just disclose the 2020 nondeductible contribution and when you file your 2021 taxes that form 8606 will have a nondeductible amount to carry over and a larger conversion amount.
We mentioned earlier that your IRAs are your own and what one spouse has doesn’t impact the other’s ability to complete a Backdoor Roth conversion. That also means that if you both want to do this you have to file two 8606 forms. Do not list both your transactions on a single form.
Checking to make sure you do this correctly is important, but even if you outsource it to a tax pro it doesn’t hurt to check when reviewing your return prior to filing. If your situation mirrors the example we listed and you find an amount other than 0 listed on line 2, 14, 15c, or 18 of form 8606 or line 4b of your 1040, you should have a conversation with your tax preparer to understand why. Remember, everyone makes mistakes, and this is one easy place where they tend to show up if there was miscommunication.
Completing a Backdoor Roth conversion is usually hardest the first year. Once you have a system in place to follow, the process gets easier. Remember to check each year for changes to the IRS forms and continue to save documentation of each step to stay out of trouble. The Backdoor Roth IRA conversion is still as relevant in 2021 as it was in 2010. Discussions of rising tax rates are always in the horizon making a tax-free retirement bucket very appealing. If you would like to discuss this, or other financial planning strategies, in more detail please reach out to schedule a call.