Updates - Monetary Policy

Backdoor Roth IRAs Are Promising—and Perilous

The Wall Street Journal
Laura Saunders
 ET

It’s easy to see why: Roth IRAs offer both tax-free growth and tax-free withdrawals on contributions of after-tax dollars. Savers can put in up to $7,000 this year, or $8,000 if age 50 or older.

The trouble is, you can’t make direct contributions to a Roth IRA if your income is too high. This year the limit begins to take effect at $146,000 for single filers and $230,000 for joint filers.The good news is that backdoor Roth IRAs are a legal way around the limit. Even the name is fun, implying a sly way to beat the tax code at its own convoluted game.Look before you leap into a backdoor Roth, however. While it can be a great move, there are potential pitfalls. Some savers opting in face unexpected tax bills right away plus record-keeping headaches that last for years—or even decades.That’s because the rules for backdoor Roth IRAs aren’t intuitive. “Intelligent educated people easily miss the nuances and get into trouble they didn’t expect,” says Thom Hall, an adviser with Carson Wealth.Raghu Nair, a Silicon Valley software engineer looking into backdoor Roths IRAs, agrees: “I work in a STEM area, but tax law is so arcane. With a backdoor Roth, someone can owe tax on an after-tax transaction based on a pretax account balance.”

How to go through the backdoor

Here are issues to beware of if you earn too much to contribute directly to a Roth IRA, plus fixes for savers facing pitfalls.A backdoor Roth IRA is a two-step process. In Step One, the saver makes a nondeductible contribution of after-tax dollars to a traditional IRA. As noted above, the limit is either $7,000 or $8,000, and the IRA owner must file IRS Form 8606 with the tax return listing the contribution.In Step Two, the saver aims to transfer nondeductible funds from the traditional IRA to a new or existing Roth IRA. The law isn’t clear about timing, but specialists often recommend waiting a month before this conversion. While investment growth after the contribution will be taxable, it’s likely to be nil or small if the conversion is done soon.Step Two is where trouble arises. If the saver has funds in IRAs holding deductible contributions—as many do—the law’s onerous “pro rata” rules come into play. The result is often a surprise tax bill.Example: Lee earns too much to make a direct Roth IRA contribution, and he wants to do a backdoor Roth IRA. He puts $7,000 into a traditional IRA, doesn’t get a deduction for it, and parks it in cash.

In a month he converts $7,000 to a Roth IRA.But Lee has another traditional IRA holding $100,000 of deductible funds and their growth. Under the law, a saver only owns one traditional IRA—even if parts of it are at different brokerage firms or some funds were deductible and others weren’t. And if an IRA holds both deductible and nondeductible funds, then withdrawals are deemed to come from them proportionately.Result: Because Lee’s $7,000 transfer to a Roth IRA equals about 6.5% of his total IRA funds of $107,000, only that percentage of his transfer to the Roth IRA, or $455, is from his IRA funds that weren’t deducted. That portion is tax-free.The other $6,545 of the transfer is from his deductible IRA funds (plus growth on them), and it’s taxed at ordinary income rates. Although Lee wants to convert only his $7,000 of after-tax dollars to a Roth IRA at little or no tax cost, he can’t.Next come the record-keeping headaches. Future withdrawals must be pro rata as well, whether they are for conversions or not. So savers like Lee need good records to avoid overpaying tax on part of their withdrawals. If they leave the IRA to heirs, the heirs will need these records as well.“The record-keeping is a life sentence, unless people convert everything to a Roth IRA,” says IRA specialist Ed Slott. He thinks many heirs of traditional IRAs are overpaying tax on nondeductible amounts.

Avoiding the pitfalls

To be sure, backdoor Roth IRA conversions don’t always have these problems. If the saver has no traditional IRA holding deductible funds, surprise tax or record-keeping issues will be minimized.So-called mega-backdoor Roth 401(k) workplace plans bypass the problems too, as the rules for 401(k)s differ from those for IRAs. These plans also typically allow for higher contributions, and they’re often a better option than backdoor Roth IRAs for employees who have access.For savers with traditional IRAs who could fall into backdoor Roth traps—or already have—there are workarounds. If the amount of the traditional IRA is small, consider converting the entire amount to a Roth to clear the way for future backdoor conversions. This will bring a tax bill, but it might be worth paying now to reap tax-free benefits and avoid hassles.A traditional IRA owner can also roll deductible funds and earnings into his or her current 401(k) plan, if the employer allows it.

This leaves the nondeductible IRA dollars behind, and they can be used for backdoor Roths. Carson Wealth’s Hall says he often recommends this move.In addition, workers with health-savings accounts are allowed a one-time, tax-free rollover of IRA funds into their HSAs. This move also excludes nondeductible IRA funds. For 2024 the maximum rollover is $8,300 for a family and $4,150 for an individual, plus $1,000 for participants age 55 and older.Be aware, though, that the rollover amount is deducted from the total allowed HSA contribution. Savers can’t double dip on this funding.Savers 70 ½ or older have yet another option: Qualified Charitable Distributions, or QCDs, are made with deductible IRA funds and earnings.QCDs are already a highly tax-efficient move for many seniors who are charitably-minded. Although these IRA owners may not want to do backdoor Roths, making donations with QCDs will shrink the taxable funds in the IRA and help reduce tax on future withdrawals.

Have a Tax Dilemma?