Using the Back Door | Lord Abbett
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Retirement Perspectives

For some the only way into a Roth is through the back door.

Read time: 4 minutes

 

For individuals who want to make a Roth IRA contribution but their income exceeds the threshold: Enter the concept of a “Backdoor Roth IRA.”

 

Tax deferred growth, no lifetime required minimum distributions, potential tax-free distributions. These are a good reasons to consider a Roth IRA. However, individuals with certain incomes in 2021 (over $140,000 in modified adjusted gross income for single people or over $208,000 for those married filing jointly) are not allowed to contribute directly to a Roth IRA.

So what can they do? Enter the back-door Roth IRA strategy.

A way for high income earners to sidestep a Roth IRA’s income limits

The Backdoor Roth IRA is a strategy that allows those high-income earners that are phased out of making contributions directly to a Roth IRA to look to take advantage of its potential benefits. Basically, it is a workaround bypassing the annual Roth IRA income threshold.

Instead of making contributions directly to a Roth IRA, a high-income earner will first make a non-deductible (after-tax) contribution to a traditional IRA, and then subsequently convert it to a Roth IRA. Once the traditional IRA has been funded, and as soon as the IRA provider permits, the investor may convert the traditional IRA proceeds to a Roth IRA. This can usually be done in a matter of days. Given such a short holding period, there likely will be little or no appreciation in the account, and, consequently, little or no tax incurred.

PRACTICE TIP: Virtually everyone is eligible to make a non-deductible (after-tax) contribution to a traditional IRA, which does not impose any income and or age restriction. In 2020 the SECURE Act removed the age cap (previously 70 ½) for making traditional IRA contributions.

What’s the catch?

The caveat is the IRS’s “pro-rata” distribution rule that is triggered upon conversion. This rule clearly states that IRA account holders must aggregate values in all their traditional IRAs (including SEP and SIMPLE) when determining the amount subject to taxation upon converting funds to a Roth IRA. In other words, for existing IRAs (excluding Roth IRAs), pre-tax contributions, and any earnings —including accounts that are not converted—will be taxed as if a distribution occurred.

So 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 is taxable. Therefore, the backdoor strategy tends to work best for investors who don’t already own a traditional IRA (including SEP and SIMPLE).

Example:

  • Tina has an existing traditional IRA currently valued at $5,000. All funds are untaxed (i.e. composed of pre-tax contributions plus earnings).
  • She makes a non-deductible (after-tax) contribution of $5,000 to a separate (different) traditional IRA and subsequently converts the funds ($5,000) to a Roth IRA.
  • Both IRAs total $10,000, of which $5,000 is after-tax. 50% of her account is pre-tax so a conversion of $5,000 is therefore 50% taxable.
  • Tina will owe income tax on $2,500 (50%) of the converted amount ($5,000).

Reporting Roth IRA contributions

After-tax contributions are reported and tracked by the IRS via IRS Form 8606, “Nondeductible IRAs”. Taxpayers are required to file the 8606 with their federal tax return. The 8606 is also needed for certain transactions:

  • Contributing non-deductible (after-tax) amounts to a traditional IRA.
  • 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.

If the 8606 is not filed on a timely basis (an all too common occurrence), the IRS will not be aware of an individual’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!  More on that here. Tip: Consult your tax advisor when contemplating a Roth back door strategy.

Pro-rata workaround: A workaround exists for those individuals that have traditional IRAs (including SEP and SIMPLE) containing pre-tax dollars. Qualified plan accounts (e.g., 401(k), 403(b), 457(b)) are not included in the pro-rata calculation, thus offering individuals the ability to roll pre-tax IRAs funds into their employer sponsored retirement account.

Frequently asked questions

Q. Assuming an individual has multiple IRAs that include both pre-tax and after-tax contributions, how are taxes calculated when traditional IRA funds are converted to a Roth IRA?
A. 
For tax purposes, IRS rules require aggregation of all individual IRAs, effectively treating them collectively as one single IRA, regardless of whether they contain pre-tax or after-tax dollars. Taxpayers should report and track their after-tax contributions on IRS Form 8606, which is used to determine how much a distribution or conversion is subject to income taxes. 

The pro-rata calculation is determined by taking the aggregated year account value of all individual IRAs (excluding Roth and inherited IRAs) and dividing that figure into the total amount of all after-tax dollars. The resulting percentage (called “basis recovery”) is then applied to the distribution to determine the tax-free portion of the withdrawal.

Q. What type(s) of IRAs are including 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 IRA and all inherited IRAs are excluded.

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 qualified plan accounts, such as 401(k)s, play a role in the pro-rata calculation?
A.
 Qualified plan assets such as 401(k)s are 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.

Investors with large IRAs could potentially roll over their pre-tax dollars into their 401(k) account (assuming their current employer offers a plan and allows for rollovers), thus excluding those assets from consideration in the pro-rata formula and offering a potential tax-free Roth conversion.

Q. Can I change my mind?
A. 
No. The Tax Cuts and Jobs Act of 2017 repealed recharacterizations of Roth conversions. A Roth conversion is irrevocable.  See our article on this subject.

 

Key Takeaways

  • High income earners can look to take advantage of a “back door” strategy aim to achieve the potential tax benefits of a Roth IRA.
  • Be aware that the IRS’s “pro-rata” distribution rule is triggered upon conversion and IRA account holders must aggregate values in all their traditional IRAs. A tax advisor should be consulted.

 

To comply with Treasury Department regulations, we inform you that, unless otherwise expressly indicated, any tax information contained herein is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under the Internal Revenue Code or any other applicable tax law, or (ii) promoting, marketing, or recommending to another party any transaction, arrangement, or other matter.

The information is being provided for general educational purposes only and is not intended to provide legal or tax advice. You should consult your own legal or tax advisor for guidance on regulatory compliance matters. Any examples provided are for informational purposes only and are not intended to be reflective of actual results and are not indicative of any particular client situation.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett's products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

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