As we get closer to the end of the year, one strategy that I wish I had known years ago was the Backdoor Roth IRA. As a tech professional, it was not unusual when our household income would exceed the standard Roth IRA contribution income limit. Because no one told me about this strategy, I went years without putting funds into my Roth IRA bucket, thinking it was because I was disqualified. My "trusted" advisor never told me about this strategy, nor did he remind me to consider putting my funds into a Roth IRA bucket. Time lost is not something you can make up. This was a costly lost opportunity.
I work with my clients now and the Backdoor Roth is something I'm keenly mindful of as a tool in the planning toolbox. Depending on the client's situation, it may or may not be the right tool, or it may or may not be the right time to use the tool. This is why you should consult your professional advisor before executing this strategy.
What is a Backdoor Roth?
Here's a summary of the items to be aware of when considering a Backdoor Roth:
The backdoor Roth IRA is a strategy that allows individuals exceeding Roth IRA contribution limits to contribute money into a Roth IRA and grow it tax-free.
It's important to note that the backdoor Roth IRA is not a different type of Roth IRA. It's still a traditional Roth IRA. It's just funded using a method different from the conventional direct contribution. Both methods are IRS-sanctioned. (Side note: In 2022, Congress attempted unsuccessfully to end this funding method.)
Rules and considerations:
The Roth IRA has income limits for direct contributions.
In 2024, it's phased out between $146,000 and $161,000 for single filers and $230,000 and $240,000 for joint filers.
In 2023, it's phased out between $138,000 and $153,000 for single filers and $218,000 and $228,000 for joint filers.
You can contribute up to $7,000 in 2024 ($8,000 for 50+) to a traditional IRA and Roth IRA combined. (In 2023, you can contribute up to $6,500 ($7,500 for 50+).)
For a backdoor Roth IRA, first make a non-deductible contribution to your traditional IRA. Non-deductible means you don't get a tax break upfront.
Shortly after the non-deductible contribution to your IRA, convert it to a Roth IRA. (Up until 2010, there was an income limit for Roth IRA conversions.) There is currently no limit to how much you can convert from a traditional IRA to a Roth IRA. You owe taxes on the amount you convert based on your ordinary income tax rate.
Because your non-deductible contribution is made with after-tax money, and because the Roth conversion took place shortly after the non-deductible contribution with $0 untaxed gains, your Roth conversion would result in a $0 tax liability.
Beware of the Pro-Rata rule: Any existing pre-tax money in your traditional IRA (employer 401k is excluded) gets "mixed" with the non-deductible contribution upon conversion. You'll owe taxes on a portion of the converted amount based on the ratio of pre-tax and non-deductible funds.
Five-Year Rule: You can't withdraw converted funds (earnings or contributions) penalty-free for five years after the first conversion in that Roth IRA.
One Roth Conversion per Calendar Year: While there is no rule to how many times you can complete a Roth conversion within a year, due to fees and administrative tracking, it's best to stick to one conversion per calendar year as a best practice.
WARNING: Consult with a tax professional! Backdoor Roth IRAs can be complex and may not be the most suitable solution for your specific situation.
Why Roth IRA?
I'm not going into the Roth IRA vs Traditional IRA in this article. However, I want to I highlight the advantages of having a Roth IRA.
Tax-Free Growth: Roth IRAs allow your money to grow tax-free, potentially boosting your retirement income significantly.
Flexibility: Except for your converted amount, which has the Five-Year Rule applied, you can access your Roth contributions (not earnings) without penalty at any time.
No RMD: Required Minimum Distribution rules do not apply to Roth IRAs. This allows you to keep and grow your Roth IRA until the end of your life.
Possible Future-Proof: Tax rates may increase in the future. Your income may also increase, pushing you to the next tax bracket. Locking in current rates on future growth can be advantageous in particular situations.
How to Report Backdoor Roth IRA on Your Tax Return?
Determining whether the Backdoor Roth is a suitable tool to use in your specific situation is the first step. Executing the Backdoor Roth is the second step. However, there is one more step that is often overlooked that could negate all the work you did to complete the Backdoor Roth. Reporting the contribution and conversion accordingly is a critical third step.
Sometime in Q1, you should receive the following tax forms related to your backdoor Roth.
Form 5498 - This reports the amount you contributed to your traditional IRA. In the example below, there was a $6000 contribution (Line 1) to the IRA (Line 7).
Form 1099-R - This reports the amount you distributed from your traditional IRA. In this example, there was a $6000 distribution (Line 1) from your IRA. Even though Line 2a indicates that the $6000 is taxable, Line 2b is checked because the custodian does not know what type of transaction this is. They only know there's a contribution and a distribution. This is why 2b is checked.
Form 5498 - This is the third form you will receive. This is different from the first 5498 from the traditional IRA account because this Form 5498 is from your Roth IRA. Line 3 indicates there was a Roth IRA conversion that took place.
Using these three tax forms, you're now ready to complete the critical last step in your tax filing. You'll need to file Form 8606 with your tax return. This form reports to the IRS that your initial IRA contribution was non-deductible. Remember, this non-deductible contribution uses your "after-tax" funds, meaning you've already been taxed on this money. Your conversion of the "after-tax" funds that received a $0 gain means this taxable event yielded a tax consequence of $0. The completed Form 8606 will look something like this.
Finally, to double-check to make sure you've done this correctly, go back to your Form 1040 (Page 1 of your tax return) and ensure that your IRA distributions and the taxable amount on Lines 4a and 4b are completed correctly.
Is Backdoor Roth Right for You?
I started the article with a personal example of why I wished my advisor would've educated me on the benefits of a Backdoor Roth. However, now that I'm on this side of the table, as a financial planner, I have seen situations where a Backdoor Roth is not the best and most appropriate strategy for a high-income household. These situations are unique, but speaking with someone who knows this well regarding your situation is absolutely relevant and necessary. Beware of Bone Collectors also, as they may not be able to give you the most unbiased opinion about this strategy. You may be in the camp where there's a better strategy for you than using the Backdoor Roth.
Documentation: Keep all paperwork related to contributions, conversions, and basis calculations. Yes, your tax or financial planner should have all this data. But ultimately, the responsibility lies with you. Make sure you have a record of these items yourself.
Tax software: Using tax software with backdoor Roth capabilities can simplify reporting.
Consult Early and Often: Discuss your backdoor Roth plans with your tax and financial planner early in the year to ensure proper timing and reporting strategies.
Follow IRS Required Reporting: It's essential to follow IRS rules and properly report all contributions and conversions to avoid penalties or tax issues.
WARNING: It bears repeating that you should consult a tax professional on any tax-related matters. What I have illustrated here is for educational purposes only and is not a broad recommendation for everyone. Backdoor Roth IRAs can be complex, and it may not be the most suitable solution for your specific situation.