During a recent Lord Abbett webinar on retirement account strategies and deadlines (register to view a replay), we received over 100 questions from advisors on a range of retirement-related topics. We answered as many as we could during the broadcast, but the sheer number of queries received inspired us to tackle some of the most asked-about topics in upcoming columns. This time, we’ll look at the “backdoor” Roth IRA strategy.

Tax-deferred growth, no lifetime required minimum distributions, tax-free distributions. These are all good reasons to establish a Roth IRA. Why doesn’t everyone contribute to a Roth IRA? Some individuals may prefer receiving an immediate tax deduction by contributing to a traditional IRA and/or a 401(k) plan. Many more retirement savers don’t have the option to contribute to a Roth IRA. For a Roth IRA, unlike a traditional IRA, eligibility is limited based on income.

Enter the “backdoor” Roth IRA strategy.
The income phase-out ranges for 2024 for funding a Roth IRA via a direct contribution are $230,000−$240,000 for married couples filing jointly and $146,000−$161,000 for single filers.

The "backdoor Roth IRA" has become an annual practice—allowing for an indirect Roth IRA contribution if your income is too high to qualify for a direct (Roth IRA) contribution. The backdoor Roth IRA is a strategy where an individual contributes to a traditional IRA and subsequently converts that contribution to a Roth IRA—a sound and popular way to bypass the income limits on Roth contributions. Income limits however do not apply for making a non-deductible, traditional IRA contribution. Despite the rules that restrict eligibility for direct contributions, all taxpayers, regardless of age or income, can convert retirement savings to a Roth IRA.

Importantly, the account owner must have compensation (earned income). Without compensation, a traditional IRA contribution is not allowed. Those eligible individuals can contribute (for 2024) up to $7,000 ($8,000 for those 50 or older).

1. Make a non-deductible, traditional IRA contribution. Virtually everyone is eligible to make a non-deductible (after-tax) contribution to a traditional IRA, which does not impose an income and/or age restriction. However, compensation (earned income) is required.
2. Convert the contribution to a Roth IRA. Once the traditional IRA has been funded, and as practical, the investor can convert the (traditional IRA) contribution to a Roth IRA. While the IRS has no official rules on the amount of time that must elapse between the non-deductible IRA contribution and the Roth conversion, we urge investors to discuss an appropriate “holding period” with their financial and/or tax professional.
3. Report the transaction on IRS Form 8606 “Non-Deductible IRAs.” 

Example: Backdoor Roth IRA

Amy, age 42 and single, has $225,000 of income. Amy, due to her high income, is ineligible to make a direct Roth IRA contribution. Instead, she makes a $7,000 non-deductible, traditional IRA contribution and converts the contribution shortly thereafter.

What’s the catch?

An account owner cannot cherry pick after-tax dollars in their IRA and only convert those funds. Instead, the IRS looks at all IRAs (including SEPs and SIMPLEs) as one single IRA. The ratio of after-tax dollars versus pre-tax dollars determines the taxability of the conversion. This is commonly known as the “pro-rata” distribution rule that is triggered upon conversion. This rule clearly states that when determining the tax consequences of an IRA distribution, which includes a Roth conversion—an IRA owner must aggregate the value in all of their IRAs (traditional, SEP, SIMPLE, and Rollover IRA) for the purpose of determining the amount subject to taxation upon converting funds to a Roth IRA. IRS Form 8606 states on line 6: “Enter the value of all your traditional, SEP, and SIMPLE IRAs as of December 31.” The value of your Roth IRA is excluded from this calculation.

Pro-rata rule looks at all your non-Roth IRA accounts (including SEP and SIMPLEs) as of December 31 of the year of the conversion.

A non-deductible contribution made to a traditional IRA can be converted to a Roth IRA, but, if you have other IRA funds, then you must use the pro-rata rule to determine how much of the conversion dollars is taxable. Therefore, the backdoor strategy tends to work best for investors who don’t already own a traditional IRA (including SEP, SIMPLE or Rollover).

EXAMPLE: backdoor Roth (multiple IRAs)

• Tony has an existing traditional IRA valued at $5,000, consisting of all pre-tax dollars.
• He makes a non-deductible, traditional IRA contribution of $5,000 and thereafter converts the contribution ($5,000) to his Roth IRA.
  
• His total IRA balance is now $10,000, of which $5,000 (50%) is after-tax. The other 50% of his account is pre-tax, so a conversion of $5,000 is therefore 50% taxable.
  
• Tony will owe income tax on $2,500 of the converted amount ($5,000).
  

As this example illustrates, non-deductible, traditional IRA contributions are mixed into an aggregation of all an owner’s non-Roth IRAs; every distribution (including a Roth conversion) includes some portion of non-deductible and taxable funds. Since the pro-rata rule specifies that a proportionate amount of pre- and after-tax dollars gets converted, Tony will have to check his traditional IRA basis each year prospectively for almost any withdrawal or conversion.

It would make no difference if Tony contributed $5,000 to a new or existing IRA at a different IRA custodian. Why? The IRS views all an account owner’s IRAs (including SEPs and SIMPLEs) as one single account.

One can reduce or even eliminate pre-tax IRA funds, therefore avoiding the pro-rata rule. Bypassing the pro-rata rule on the Roth conversion portion of the backdoor Roth strategy requires the account owner to have $0 of pre-tax money in all non-Roth IRAs at the end of the year of the conversion (i.e., December 31).

An approach to bypass the pro-rata rule: do a “reverse rollover” by rolling all pre-tax IRA funds into a non-IRA-based employer-sponsored workplace retirement plan such as a 401k, 403(b), governmental 457(b) (although the plan must allow for the rollover).

A reverse-rollover “empties” pre-tax IRA funds. In other words, if you have rolled over your pre-tax IRA(s) to a 401(k) during that year, you’ll be left with only after-tax funds as of December 31, and the conversion will be potentially tax-free. And you still can “reverse the reverse rollover” by rolling the 401(k) funds back to the IRA in the next year.

Other pro-rata workarounds include doing a full Roth conversion of all IRA assets (although pre-tax funds are subject to income tax) or making a Qualified Charitable Distribution (QCD). QCDs are an exception to the pro-rata rule. QCDs can only be made with pre-tax IRA funds.

Taxpayers who make non-deductible (after-tax), traditional IRA contributions must file IRS form 8606 with their federal tax return. Form 8606 needs to be filed for certain other transactions including:

• Taking a distribution from a traditional, SEP, or SIMPLE IRA that contains basis (e.g., after-tax dollars).
• Taking a distribution from a Roth IRA.
  
• Conversions from traditional, SEP or SIMPLE IRAs to Roth IRAs.
  
• Rollovers of after-tax dollars from employer-sponsored plans, such as 401(k)s, to an IRA.
  

Should a taxpayer not file form 8606 in a timely manner (an all-too-common occurrence), the IRS will not be aware of a taxpayer’s IRA basis. Without that knowledge, the IRS could expect to collect taxes on funds being distributed. In other words, the investor could potentially be taxed twice! Therefore, it’s critical to know about every dollar regardless of where an IRA is held, even if accounts are spread among different IRA custodians.

Q. What type(s) of IRAs are included in the pro-rata calculation?
A. The value of all an individual’s IRAs, whether traditional, rollover, SEP, and/or SIMPLE IRAs, are included in the pro-rata formula. Notably, Roth IRAs and all inherited IRAs are excluded.

Qualified plan assets such as 401(k)s are also excluded. However, an IRA rollover from an existing employer-sponsored plan (e.g., 401(k), 403(b), etc.) in the same calendar year could affect the amount subject to taxation.

Q. Are both spouses’ IRAs included in the pro-rata calculation?
A. No. Instead, the formula includes only IRAs owned by the spouse completing the transaction.

Q. Can I change my mind?
A. No. A Roth conversion is irrevocable.

Questions? Please contact your Lord Abbett representative at 888-522-2388.