Tax season always seems to have one special issue du jour. But every year, backdoor Roth IRAs are a hot topic, especially on the White Coat Investor forum. Because of that, I’ve written this blog post to help beginners understand what they are, why they are important for high-income professionals (“HIPs”), and how they work.
Let’s start with the basics and assume you are setting up a Roth to invest for retirement, meaning we won’t discuss details like the 5-year rule:
- A Roth IRA is a personal retirement account you can deposit up to [2022 limits] $6,000/year ($7,000 if age 50+) into as long as you have at least that much earned income but don’t earn too much money (see below).
- It is a privately-owned account as opposed to an employer account. The two have no correlation.
- You get no tax deduction for putting money in a Roth IRA but everything that comes out is tax free, no matter how you use it. This gives you a fabulous incentive to grow your Roth as much as possible.
- If your spouse does not work, you can also contribute the same amount to a spousal Roth IRA as long as you make at least twice the annual limit (enough for you and enough for your spouse).
- You can pass your Roth to your heirs and it is tax free to them, also.
- Note: your Roth beneficiary(ies) may be required to empty the Roth over a 10-year timeline under the SECURE Act (bg 1/1/2020)
- You do not have to take Required Minimum Distributions (RMD’s) at age 72, as you do for TIRAs and 401k’s.
You won’t find a bigger cheerleader for Roth IRAs than I. I think everyone should contribute to a personal Roth for both spouses and consider contributing to a work Roth IRA if offered. Maybe that should be an upcoming article.
But there’s a problem: Most of our clients don’t qualify to contribute directly to a personal Roth IRA because they make too much money. In fact, most attendings are barred from contributing to a Roth IRA.
That’s where the “backdoor Roth” comes in. Due to a quirk in the tax laws, the wealthiest businessperson can take advantage of the tax-free growth of a Roth IRA by contributing indirectly via a circuitous route known as the “backdoor Roth”. If you have any pre-tax money in IRA accounts, including SEP, SIMPLE, rollover IRAs, or Traditional IRAs (known as TIRAs), you will be taxed on the conversion.
Here’s why it works:
- The government affords taxpayers two ways to move money into a Roth IRA –
- By a direct contribution and
- By a conversion from a Traditional IRA (or “TIRA”).
A backdoor Roth takes advantage of the option to convert funds from a TIRA. Instead of one step (direct contribution), you move money into a Roth IRA in two steps and then report the transaction (step 3) as follows:
- Step 1: make a nondeductible contribution to a TIRA.
- Anybody with earned income can contribute to a TIRA because there are no income limitations. The only question is whether or not your contribution is deductible.
- This contribution should be kept in a MMF (Money Market Fund) and not invested until you complete Step 2.
- Step 2: convert the balance in the TIRA to a Roth IRA
- Anybody can convert an IRA to a Roth IRA. There are no longer any income limitations.
- You’re now ready to invest in a well-balanced equity portfolio.
- Step 3 is to report both step 1 and step 2 on IRS form 8606 for the applicable year(s). Form 8606 is a very important form because it records your “basis” with the IRS.
- The nondeductible contribution to the TIRA is reported on the front of form 8606, or page 1.
- The conversion to the Roth (any conversion to a Roth IRA) is reported on page 2, the back of form 8606.
A word about your “basis”: Your “basis” is the amount of your IRA contribution that you have already paid taxes on. If the IRS does not have a record of your basis, it can attempt to tax not only your original contributions, but all of the earnings on your Roth IRA since inception. Form 8606 is your official notification to the IRS that you have “basis” in your nondeductible TIRA (step 1) and in your Roth conversion (step 2). So, as you can see, it is very important to file those forms 8606 to record your backdoor Roth IRA basis with the IRS every year for both step 1 and step 2.
The backdoor Roth maneuver is really not a difficult process. So why is there so much confusion over it? A couple of reasons.
First of all, for timing reasons.
- Your Step 1 initial TIRA contributions are made on a tax-filing year basis. That means you have from 1/1/x1 until 4/15/x2 to contribute to your nondeductible TIRA. That also means you can contribute to a TIRA for 2 years at once from 1/1/x1 through 4/15/x1. That’s confusing!
- Your Step 2 backdoor conversion is reported on a calendar year basis. That means if you contribute to a nondeductible TIRA on 2/1/22 for the year 2021 and convert it on 2/10/22, you will need to report the process on tax returns for 2 years (2021 for the contribution and 2022 for the conversion. Even though you have done this in 2 days, you have to wait a year to report both transactions!
Second, a lot of tax preparers don’t know anything about backdoor Roth IRAs. This is a “maneuver”, not something that is implicitly explained in black and white in the tax code (even though Congress okayed this maneuver in TCJA 2017) . Have you ever noticed how CPAs tend to dress in black and white and wouldn’t think of signing a form in blue ink? If we haven’t listened to the sermon, it’s not in our bible, if you know what I mean.
Every tax filing season, new clients contact us who have had to teach their CPA how to do a backdoor Roth conversion or whose tax preparer has not filed the form 8606 for the conversion. Yes, you can catch up and file those old forms 8606, but you may have to pay $50 for every year you file late. Yes, I think your tax preparer should pick up the tab.
You have until your tax filing due date (not including extensions) to complete step 1 of your backdoor Roth. Go ahead and contribute to your TIRA and file form 8606, even if you’ve already filed your income tax return. Open IRA accounts at your custodian of choice and contribute $6,000/$7,000 per spouse for 2019.
So why are we so big on Roth IRAs at Fox Wealth Management? Only $6,000 a year – how much difference can that make, anyway? And why would a family earning a cool million+ a year want to contribute $6,000 to an account that won’t even give you a tax deduction? You might be surprised.