The “Backdoor Roth IRA” is a sophisticated yet legal strategy tailored for high-income earners whose modified adjusted gross income (MAGI) exceeds the IRS thresholds for direct Roth IRA contributions. The workaround involves making a nondeductible contribution to a Traditional IRA—permitted regardless of income—followed by a conversion of those funds into a Roth IRA. Once in the Roth IRA, the converted amount and its subsequent earnings grow tax-free, with qualified withdrawals in retirement also exempt from taxation. This is a fully legal workaround recognized by the IRS, but it requires careful execution to avoid potential pitfalls, such as unexpected tax liabilities or compliance issues. For additional questions or personalized guidance, schedule a consultation with us.
Process / Steps
Step 1
Make a Nondeductible Contribution Into a Traditional IRA
Step 2
Convert Traditional IRA into a Roth IRA
Ensure a Roth IRA is in place—open one if necessary—before proceeding with the conversion. Transfer the Traditional IRA funds, including the contribution and any earnings, to the Roth IRA. The process varies by financial institution; some facilitate online transfers, while others require paperwork—consult your brokerage for details. Complete the conversion promptly, ideally within days or weeks of funding the Traditional IRA, to minimize taxable earnings. If gains accrue (e.g., from interest or investments) before conversion, those earnings are taxed as ordinary income, though the nondeductible contribution itself typically remains untaxed.
Step 3
Navigate the Pro-Rata Rule
The IRS prohibits isolating after-tax dollars for conversion if you hold multiple IRA accounts. It aggregates all Traditional, SEP, and SIMPLE IRAs (excluding 401(k)s) as a single account for tax purposes, evaluated as of December 31 of the conversion year. Under the pro-rata rule, pre-tax balances (e.g., from deductible contributions or rollovers) in these IRAs render a portion of the conversion taxable, proportional to the ratio of pre-tax to after-tax funds across all accounts. This can result in an unexpected tax liability, making it essential to assess your total IRA holdings before converting. Using a “new” Traditional IRA with no pre-tax funds, as outlined in Step 1, simplifies compliance and clarifies conversion options.
Step 4
File Form 8606 with Your Tax Return
IRS Form 8606 is vital for documenting nondeductible Traditional IRA contributions and conversions. File it annually with your tax return—typically due April 15—to establish your “basis” (the after-tax amount contributed), preventing double taxation upon conversion. The form also determines any taxable portion of the conversion, such as earnings or pro-rata amounts. Accurate filing is crucial; errors or omissions can lead to penalties or tax disputes. Retain Form 8606 records indefinitely to substantiate the tax-free status of your Roth IRA in retirement.
Pro-rata Rule
Overview of Pro-rata Rule
The pro-rata rule governs the taxable portion of distributions or conversions from Traditional, SEP, or SIMPLE IRAs, calculated based on the ratio of pre-tax (tax-deferred) to after-tax (nondeductible) funds across all such accounts as of December 31 of the tax year. This rule directly impacts the Backdoor Roth IRA strategy, as it applies when converting Traditional IRA funds to a Roth IRA, potentially reducing the tax-free benefits if pre-tax balances exist.
Example
Consider an individual with $93,000 in pre-tax funds in an existing Traditional IRA who contributes $7,000 nondeductible to a new Traditional IRA, totaling $100,000 across all Traditional, SEP, and SIMPLE IRAs. To convert the $7,000 to a Roth IRA, the taxable portion is determined using the pro-rata rule. The formula is as follows:
- Non-taxable percentage = Nondeductible amount ÷ Total non-Roth IRA balances
- Example: $7,000 / $100,000 = 7%
- Non-taxable conversion amount = Conversion amount × Non-taxable percentage
- Example: $7,000 x 7% = $490
Thus, $490 of the $7,000 conversion is non-taxable (already taxed as a nondeductible contribution), while the remaining $6,510 is taxable as ordinary income. This tax liability can diminish the advantages of the Backdoor Roth IRA, particularly for high-income earners aiming for tax-free growth and withdrawals. Careful planning is essential to assess the rule’s impact before proceeding.
Avoiding The Pro-rata Rule
To minimize the pro-rata rule’s effect, consider rolling over pre-tax funds from Traditional, SEP, or SIMPLE IRAs into an employer-sponsored 401(k) plan, if the plan permits and you are eligible. This reduces the pre-tax IRA balance, potentially lowering or eliminating the taxable portion of the Roth conversion. The rollover must be completed before December 31 of the conversion year, as the IRS evaluates IRA balances on that date.
Form 8606
Form 8606 is a vital IRS tax form necessary for successfully executing the Backdoor Roth IRA strategy. It records the nondeductible Traditional IRA contribution from Step 1, made with after-tax dollars, establishing your “basis” in the account. This basis is essential because it prevents double taxation—ensuring the IRS recognizes the portion of your contributions on which you’ve already paid taxes. Retain Form 8606 records indefinitely to support the tax-free status of your Roth IRA in retirement.
Form 8606 Example
Example: If you followed the above steps, and had no IRA account balance as of December 31 your form 8606 might look like this.
FAQs
What accounts will be considered in the pro-rata calculation?
The pro-rata rule includes only Traditional IRAs, SEP IRAs, and SIMPLE IRAs when calculating the taxable portion of a distribution or conversion, such as in a Backdoor Roth IRA. These accounts are aggregated based on their balances as of December 31 of the tax year, determining the ratio of pre-tax (tax-deferred) to after-tax (nondeductible) funds. Excluded from this calculation are 401(k)s, 403(b)s, 457(b)s, Roth IRAs, and inherited IRAs (unless from a spouse). Spousal inherited IRAs rolled into your own Traditional IRA are included in the aggregation.
How do I avoid the pro-rata rule?
To minimize or eliminate the pro-rata rule’s impact, roll over pre-tax funds from Traditional IRAs, SEP IRAs, and SIMPLE IRAs into an employer-sponsored 401(k) plan, provided the plan permits such rollovers and you are eligible. This reduces the pre-tax balance in your IRAs, decreasing the taxable portion of a Roth conversion under the pro-rata calculation and potentially allowing a larger share—or all—of the conversion to be nontaxable. Complete the rollover before December 31 of the conversion year, as the IRS assesses IRA balances on that date.
What are the contribution limits for a backdoor Roth IRA?
A Backdoor Roth IRA involves making a nondeductible (after-tax) contribution to a Traditional IRA, followed by a conversion to a Roth IRA. As such, its contribution limit mirrors that of a Traditional IRA, which has no income restrictions for nondeductible contributions. This strategy enables high-income earners—whose earnings exceed the Roth IRA’s direct contribution income limits—to participate indirectly.
Can I convert my Traditional IRA at any time?
The IRS imposes no deadline for converting a Traditional IRA to a Roth IRA, allowing flexibility to convert funds on the same day as a nondeductible contribution or after months—or even years. However, we recommend converting promptly—ideally within days or weeks—to minimize taxable earnings. Any growth in the Traditional IRA before conversion, such as interest or investment gains, is taxed as ordinary income. Delaying also heightens pro-rata rule risks if pre-tax balances in other IRAs fluctuate, potentially increasing the taxable portion of the conversion.