Backdoor Roth: Not So “Hush-Hush”
- If modified adjusted gross income (MAGI) is too high to make direct Roth IRA contributions, backdoor Roth contributions can be made
- Pro-rata taxation of pre-tax IRA assets applies when implementing backdoor Roth
- Backdoor Roth contributions may be optimal once other retirement savings options (i.e. 401k’s and/or HSA’s) have been maximized
- Federal tax legislation has confirmed the legitimacy of backdoor Roth contributions
Of all the ways to save for retirement, backdoor Roth is possibly one of the most misunderstood. Perhaps it is the terminology “backdoor,” which is associated with something that is secret, hush-hush or downright improper. Who wants to consider making a “hush-hush” contribution? Let us dive into the details of this retirement savings option and explain why it may not be so “hush-hush” after all.
Put simply, a backdoor Roth contribution allows individuals to add funds to a Roth IRA if MAGI is too high to contribute directly to a Roth IRA. For 2020, individuals are phased out for direct Roth IRA contributions if MAGI is in excess of $139k (single filing) or $206k (married filing jointly). Roth IRA contributions are contributed post-tax but potentially grow tax free.
Processing a backdoor Roth contribution is somewhat roundabout (thus the “backdoor” terminology). The process involves: 1) making a traditional non-deductible IRA contribution ($6k maximum contribution in 2020 [$7k if age 50+]; you must have earned income to be eligible to make an IRA contribution); 2) converting the contribution to Roth; and 3) reporting the backdoor Roth contribution properly on your tax return.
A backdoor Roth contribution is not taxable if you do not own pre-tax IRA assets, but if you do own pre-tax IRA assets you may want to tread carefully. Pre-tax IRA assets include deductible traditional IRA contributions and earnings, SEP IRA’s and SIMPLE IRA’s and are subject to a pro-rata taxation formula upon conversion (step three above). Here is an example of how the formula works:
- $100k in pre-tax IRA assets and a $6k backdoor Roth contribution is made
- $100k pre-tax IRA assets ÷ $106k total IRA assets = 94% pro-rata taxation
- $5,640 is taxable as ordinary income ($6k Roth conversion x 94% pro-rata taxation)
Once an individual has maximized contributions to tax-advantaged retirement accounts such as a 401k and/or HSA, backdoor Roth may be the best bet. A common way to avoid pro-rata taxation may be to first roll over pre-tax IRA assets to an employer retirement plan, but this may not be optimal as some plans do not accept incoming rollovers, have high fees or have a subpar menu of investment options.
As far as backdoor Roth contributions being “hush-hush,” 2017 federal tax legislation specifically cited the legitimacy of this maneuver. However, it is important to review your own specific situation before implementing backdoor Roth contributions.
As always, please reach out to your trusted advisor with any questions.
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