September 2022
Tax Planning

Back Door Roth Strategy

For wage earners who earn too much income to contribute directly to a Roth IRA, there is another way in – but you’ll need to understand some of the details to make it work properly. 

Perhaps you have heard the term “Back Door Roth” (BDR) but didn’t know if this might apply to you.  Essentially it allows you to make a non-deductible contribution to a traditional IRA which, in turn, can be converted into a Roth IRA, allowing the money to grow tax free.  Even though you didn’t qualify to contribute to a Roth, you get to go in the back door anyway, no matter what your income.  It’s akin to entering your home through the back door, so that’s where the name stems from. 

When should I consider a “Back Door Roth” contribution? 

For starters, you’ll need to have two things:

First, you or a spouse will need to have “Earned Income” - think salary and commissions, not income from investments, social security, pensions, or distributions from IRA’s.

For 2022, if your income is below $144,000 for single filers and $214,00 for married filing jointly then you can contribute directly to a Roth IRA (just go through the front door); however, for those that find themselves above these income levels, this is where the back door might be a good solution for you.

Secondly, you’ll typically want to make sure you don’t have any existing IRA accounts in your name with a balance; otherwise, you’ll run into a problem with the IRA Aggregation rule - more on that below.

What is the process to create a back door Roth IRA?

The process is straightforward:

1.     Contribute to a traditional IRA account - given that your income is too high, this will be considered a “non-deductible” contribution.  For 2022, the contribution limits are $6,000 if you are under age 50 and $7,000 for those that are 50 and older.

2.     Convert your contribution to a Roth IRA – since the contribution was “non-deductible”, the conversion to a Roth IRA will be tax free (assuming you didn’t have any existing IRA balance and didn’t earn any money while the funds were in the IRA)

Working with your tax advisor or financial advisor can help ensure this process goes smoothly.

What do I need to know when filing my taxes?

Come tax time, a tax form 1099-R will be generated when you complete the conversion from your IRA to your Roth.  This tax form shows distributions from your IRA; however, the custodian will just assume that the distribution is taxable even though it was from a non-deductible contribution.  You’ll need to make sure that your tax advisor knows that this distribution was from a non-deductible contribution, or you may find yourself paying taxes on money that has already been taxed!  If you do your taxes yourself, you’ll want to be sure you entered it correctly with the online software. 

Also, you can expect to receive a tax form 5498 in May from your custodian that shows contributions and rollovers into the Roth IRA.  Keep the tax form 5498 for your tax records, no further action is needed. 

What if I already have an IRA? 

The situation can be a bit tricky if you already have made tax deductible contributions to an existing Traditional IRA, SEP IRA, or a SIMPLE IRA or have rolled over an employer plan, such as a 401k, into an IRA.  In this case, the IRA aggregation and pro-rata rule will apply.  The IRA aggregate rule stipulates that when an individual has multiple IRAs, they will all be treated as one account when determining the tax consequences of any distributions (including a distribution out of the account for a Roth conversion).  The standard rule for IRA distributions (and Roth conversions) is any after-tax (deductible) contributions come out along with any pre-tax (non-deductible) assets on a pro-rata basis. 

This creates a significant challenge for those who wish to do the back door Roth strategy but have other existing IRA accounts already in place.  Depending on the situation, we may be able to find a work around to make this strategy a possibility so please reach out to us so we can discuss your individual circumstances. 

And a word about timing: the IRS applies the IRA aggregation to your total IRA balance at year-end, not at the time of conversion. 

Note: The IRS does not view a 401k as an IRA, so by having a 401k it will not factor into the IRA aggregation rule.  

Need to know more?

Although this strategy has existed since 2010, the IRS has not officially commented or provided formal guidance on whether it violates the step-transaction rule.  (When applied, this rule treats what are several different steps as if they were a single transaction for tax purposes.)  Experts have mixed opinions on the likelihood of this happening, but the lack of a definitive ruling means there is some risk involved.  Before trying to implement the back door Roth strategy, we’d like to discuss this with you and your tax preparer.  This will allow us to review the pros and cons, make sure it makes sense for your individual situation, and that it is done properly.

If you have questions, please contact us.

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