Have you ever considered whether a backdoor Roth IRA makes sense for yourself? If you earn a high income, you have limits on how much you can contribute to these accounts. The backdoor Roth IRA has many benefits that can help you get more money into your retirement accounts.
Though income limits are higher for Roth IRA contributions, there is still a limit. The backdoor Roth IRA is a way to get around the income limits imposed by the IRS.
Don’t worry. The strategy is legit.
You have to make sure you follow the rules, especially when it comes time to take a distribution. When you own traditional IRAs funded with pre and after-tax dollars and Roth IRAs funded by converting traditional IRAs, you will be subject to the pro-rata rules on distribution.
Like most IRS rules, the devil is in the details. Mistakes can be costly, both in paying higher taxes and potential tax penalties for underpayment. We’ll talk about the backdoor Roth IRA and the pro-rata rule to ensure you have the knowledge you need to make good decisions at distribution time.
With that brief introduction, let’s get started. Following the discussion of how the backdoor Roth IRA works, we’ll give you step by step instructions on setting one up at Fidelity. So, stay with it until the end.
Caution: The information in this post is for informational purposes only. It is not meant to be tax, legal, or investment advice. Before taking any action, you should seek competent, professional tax and legal counsel.
Table of Contents
Roth IRA basics
Contributions and Withdrawals
Roth IRAs allow investors to contribute after-tax dollars into an IRA whose earnings like traditional IRAs grow tax-free while in the account.
In 2021, you can contribute up to $6,000 into a Roth (or traditional) IRA. For those age 50 and above, an additional $1,000 can be added, bringing the total to $7,000.
Another difference (and a significant benefit) is that you can withdraw contributions at any time without tax or penalty.
If held for five years, Roth IRA withdrawals are tax-free. If you are under age 59 1/2 and withdraw from the Roth, you will pay a ten percent penalty on earnings withdrawn. You pay no tax or penalty if you hold for five years and start after reaching age 59 1/2.
Unlike traditional IRAs, Roth IRAs do not have required minimum distributions. You decide when and how you want to withdraw money. That, to me, is another significant benefit.
Traditional IRA deductibility
Here are the 2021 contribution guidelines:
Source: IRS Deduction Limits
If you make an income above the limits listed and contribute to an employer retirement plan, you are ineligible to make a traditional IRA contribution with pre-tax dollars. What do we do if we want to contribute to a Roth IRA for the tax-free income benefits but make too much money?
Enter the Backdoor Roth
The backdoor Roth IRA is simple on the surface. The first step is to make a non-deductible contribution to an IRA. As we discussed earlier, income limits do not apply to non-deductible IRAs. Stick to the contribution limits, and you’re good to go.
For easier accounting, I recommend keeping your non-deductible IRA separate from IRAs in which you made pre-tax contributions.
Once the IRA is in place, the second step is to convert the traditional IRA to a Roth IRA. Here is where the potential pitfalls come into place. You might think that since you’ve already paid taxes on the non-deductible IRA contributions, you won’t pay taxes when you convert.
Not so fast.
Suppose you have traditional IRAs funded with pre-tax dollars, Roth IRAs funded by converting traditional IRAs, and other non-deductible IRAs. In that case, any withdrawals will be subject to the pro-rata rule. That means you will pay taxes on the converted money.
Here is an example:
Katy has an IRA worth $95,000. The entire IRA consists of pre-tax contributions and earnings. She wants to contribute to a Roth IRA but makes over $200,000, putting her over the income limit. Katy also participates in an employer retirement plan. She is over the income limit for a deductible IRA contribution as well.
Katy decides she wants to make a non-deductible contribution to an IRA. Katy decides to contribute $6,000 in 2021. She knows about the backdoor Roth and decides to convert the $6,000 to a Roth. Within a week, Katy completes the conversion, minimizing or eliminating taxes on any earnings (she left it in cash). She thinks because the money converted was after-tax, she won’t owe taxes on the converted money.
The Pro-Rata Calculation Formula
With the pro-rata rule, the IRS considers all IRAs as one IRA. That includes balances in traditional IRAs, SEP IRAS, and Simple IRAs.
Roth IRA and inherited IRA balances do not count in the calculation. Non-IRA employer plan balances get excluded as well. Here’s how to calculate the pro-rata rule:
Total after-tax amounts in all applicable IRAs (those listed above) / Total balance of all applicable IRAs = % of the tax-free distribution.
Because Katy has $95,000 in a traditional IRA consisting of pre-tax money, she will be subject to the pro-rata rule. Instead of the $6,000 conversion being tax-free, only 5.00% or $250.00 is tax-free. The remaining $$4,750 gets taxed at her ordinary income tax rate.
Here is the calculation – $6,000/101,000=5.90% or $354.00(5.90% X $6,000). Katy is married. Their combined income falls into the 24% tax bracket. *That means the tax due on the conversion $1,3500.00 ($6,000- $354 =$5,646x 24%). I’m sure Katy would not be happy getting the extra tax bill.
* The calculation may not represent Katy’s actual tax. The above example does not take into consideration tax deductions and other factors that impact the tax paid. It is meant to show how the pro-rata calculation is done.
Watch Out for This Rollover Trap
The IRA balance that matters when calculating the pro-rata rate is the year-end balance. If you converted an IRA in February and rolled over a company retirement plan to an IRA later in the year, that balance is added to the total IRA balance for the year. Because of that, it could mean a more significant percentage of the conversion amount or the non-taxable IRA balance gets taxed.
Let’s look at an example. Katy’s sister, Lisa, has an IRA balance of $100,000. That balance consists of $75,000 of pre-tax (deductible) contributions and $25,000 of after-tax (non-deductible) contributions. Lisa also has a 401 (k) worth $400,000, all of which is pre-tax money. She converts the entire $100,000 IRA to a Roth. She will owe tax on $75,000 ($25,000/$75,000=25% tax-free, 75% taxable). Remember, plan assets still in the company do not get included in the calculation.
In the early summer, Lisa changes jobs. She decides to roll the $400,000 401(k) balance into an IRA. Since the $400,000 is now in an IRA and out of the company plan, she must include in the pro-rata calculation. The total in the IRA is now $500,000 instead of $100,000. The resulting taxable income increase from $75,000 to $95,000. Here’s the calculation:
$25,000 (after tax amount) / $500,000 year-end balance ($100,000 + $400,000) = 5%. 5% x 100,000 = $5,000. That’s now the tax-free amount vs. $25,000 before the rollover. The taxable income is now $95,000 (100,000 – 5,000). Using the same 24% bracket as before, the tax goes from $18,000 to $22,800, adding an additional $4,800 to her tax bill.
Waiting until January of the following year to make the rollover eliminates the extra tax. Another option would be to roll the $400,000 401 (k) from the old company’s plan to the new company’s plan (assuming the plan allows it). Keeping the money in an employer plan means it won’t get included in the year-end balance.
Exceptions to the Pro-Rata Rule
Qualified Charitable Distributions
Qualified charitable contributions (QCDs) allow taxpayers over age 70 1/2 can transfer up to $100,000 to a qualified charity and not include the amount transferred in their income.
An ancillary benefit of this is to reduce the pre-tax amounts in the whole IRA bucket to calculate the pro-rata percentage. This only works if the taxpayer has both pre and post-tax money in IRAs.
Qualified HSA Distributions
The IRS allows taxpayers to transfer money from their IRAs to fund their Health Savings Accounts. That’s known as the qualified HSA funding distribution or QHFD. The QHFD has a limit of one transfer per year. The maximum contribution is the contribution limit for the HSA (less any contribution already made for the year). You can only pre-tax funds for the QHFD.
The most common rollover transaction is moving company-sponsored retirement plans to IRAs. There are advantages to going the other direction – rolling IRA money into an employer retirement plan. If you have large IRAs with pre-tax money in addition to after-tax or converted Roth IRA accounts, the best option may be to roll the pre-tax IRA money into your employer retirement plan. Check with the employer plan to see if they accept rollovers from IRAs. Employer plans can only receive pre-tax money. That will reduce the amount of IRA money counted for the pro-rata rule and may help reduce the taxable income.
How to Contribute to a Backdoor Roth IRA through Fidelity
Vanguard and Fidelity are two of the largest providers of IRAs and retirement plans. Below are the steps to implement a backdoor Roth IRA at Fidelity. For a look at the Vanguard process, see this post.
Fidelity Step by Step
Open A Traditional IRA
1. To fund with cash from your bank account. $6,00 ($7,000 if over age 50) if you want to maximize the contribution. Once the money is available in Fidelity, use it to fund a Money Market.
2. Next, open up a Roth IRA. Leave this unfunded.
3. Now you get to wait a day or two. There is some concern for the Step Transaction Doctrine. There has been a lot written about this, though most people would argue waiting a few days is sufficient.
Another caveat is that with Fidelity, it seems that you have to wait five business days. At least that is what I had to do. This is not the case with Vanguard, where they will let you purchase shares right away.
Fund the Roth IRA
4. Go to the upper left side of your screen and click on Accounts & Trade. Under that, go to the “Transfer funds” tab (see below).
5. Now, you should see a screen like the one below. It is a small screen in the upper left corner of the screen. You will want to transfer from your Traditional IRA to the Roth IRA.
6. After you agree to transfer funds, Fidelity will tell you this is a taxable event. You will be allowed to withhold federal taxes now. However, since you will have $0 in gains, there is no need to hold taxes. You will have $0 taxes on this. Instead, elect not to have federal taxes withheld.
7. The next screen asks you to verify the transfer. Easy peasy. Just click on the button at the bottom.
8. Once you have verified the conversion, you will need to agree to transfer the entire account. I would also opt to leave the account open (the traditional IRA account) so that you can fund it in the future.
And that’s how you do it at Fidelity.
Millennials who have been working for several years do their best to max out their 401 (k) plans as they strive for financial independence. They may find themselves with high balances in those accounts. Many of them have or will roll those plans into individual IRAs. Many will take advantage of the backdoor Roth to get their retirement money into tax-favored vehicles.
In most cases, Boomers started making contributions to traditional IRAs before Roth IRAs existed. When their income increased throughout their careers, those pre-tax contributions had to stop. That meant the best way to fund retirement was by contributing more money to their employer-sponsored plans. As they changed jobs, many rolled their old employer-sponsored plans into individual IRAs. For many Boomers, most of the IRA money is pre-tax traditional IRA accounts.
Regardless of which group you belong to, it’s essential to understand the pro-rata rules to get the most out of any distributions. For Millennials and Gen Xers, it may not seem necessary. Think about it this way. You contribute to these accounts to build up money to help you retire. In many cases, that means early retirement.
Learn the tax and distribution rules now while you’re still building your nest egg. Distribution planning should be a part of the decision on which accounts you contribute based on current tax-law and future distributions.
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