When I first heard about Individual Retirement Accounts back in 2019 on a random Dave Ramsey podcast – I had no idea what the heck it was. I was about to graduate with a Masters in Economics and had no clue about one of THE MOST important wealth building tools available to people – and school did not teach me about it. I was also shocked that less than 50% of Americans even had any type of IRA.
Starting Early
I covered the rules and benefits of a Roth IRA here and have been religiously contributing to one since. However, as my income has grown over the years, I faced a new challenge – I could no longer contribute to a Roth IRA based on IRS income limits. I learnt this the hard way and paid a hefty price back in 2022 to rectify my mistake.
Traditional IRA
Income Limits do not apply to contributing to a traditional IRA unlike a Roth IRA as these contributions tend to be tax-deferred i.e. you contribute “pre-tax” dollars into this account. Identical contribution limits apply here as to the Roth IRA and if one contributes to both traditional and roth, you cannot exceed the total annual limit on IRA contributions. However, how much can be deductible depends on IRS rules that can be found here.
Pro-Rata Rule
If you have no other IRAs, a backdoor Roth IRA conversion is simple. However, it can be more complicated if you have other IRAs. The IRS’ pro-rata rule requires you to include all of your traditional IRA assets—that means your IRAs funded with pretax (deductible) contributions as well as those funded with after-tax (nondeductible) contributions—when figuring the conversion’s taxes. Then, you pay a proportional amount of taxes on the original account’s pretax contributions and earnings.
Say you contribute $6,000 to a nondeductible traditional IRA. You also have a rollover IRA worth $94,000 from a previous 401(k) made with pretax contributions. In this case, 94% of any conversion would be taxable. Here’s the math:
- Total value of both accounts = $100,000
- Pretax contributions = $94,000
- After-tax contribution: $6,000
- $6,000÷$100,000 (expressed as percentage) = 6.0%
- $6,000 (the amount converted) x 6.0% = $360 tax-free
- $6,000 – $360 = $5,640 subject to income tax
The conversion triggers income tax on the appreciation of the after-tax contributions—but once in the Roth IRA, earnings compound tax-free. Distributions from the Roth IRA are tax-free as well, as long as you are 59½ and have held the Roth for at least five years (note that each conversion amount is subject to its own five-year holding period as it relates to tax-free withdrawals).
The Best Strategy
I consider myself lucky to have always only contributed to a Roth IRA (when I was well below the income limits) and never had a traditional IRA. So after a blunder in 2022, I opened a traditional IRA to ensure it had $0 ending balance. I contributed $6500 for 2023 and once the amount settled (2-3 days later), I immediately transferred that money over to my Roth IRA. This is called a conversion and brokerages like Charles Schwab, Vanguard and Fidelity make it a very streamlined process.
Something you need to watch out for is the small amount of interest that the $6500 can generate while it sits in cash and you need to be sure to transfer that over immediately (typically appears after the end of the first month) so your traditional IRA balance reverts to $0. You will be liable to pay your current tax rate on that small amount as it will result in a taxable event – albeit very small. Do not leave that money even if it seems small as it will trigger the pro-rata rule in future conversions.
In my opinion, the best time to do this is at the start of the year for the given year OR the start of the year for the PRIOR year – as you have a better idea about how much you earned in the prior year – you have until April 15 to contribute for the previous year.
I did my conversions for 2023 in November of 2023 and January for 2024 as I had a better idea of my tax situation for both years.
Do keep in mind since this is an “after-tax” i.e. “non-deductible” contribution, you need to report it as such to the IRS so you are not taxed when you decide to start withdrawing the money.
IRS Form 8606
This is where the IRS Form 8606 comes into play. Most tax software like TurboTax, H&R Block and freetaxusa already provide this. This form allows you to declare to the IRS – hey, I’ve contributed money to my retirement account and I am NOT deducting it because it has already been taxed. This will let them know – this money and the growth, will never be taxed again. If you fail to do this (you have upto three prior years to correct this), your future growth and principle could be liable to be double taxed.
Reap the Benefits
The beauty of this backdoor Roth conversion (not to be confused with a Mega Back Door) is that anyone can do this once they exceed the income limit thresholds for a direct contribution to their respective Roth IRAs. The best way to avoid tax complications is also to ensure you have a $0 non-Roth balance in your IRAs as you easily avoid the pro-rata rule and taxable events.
If you are consistent, file all the necessary paperwork and disciplined, you will set yourself up for a great tax-free retirement bucket which will compound more, the earlier you start.