With rising federal budget deficits creating the risk of higher taxes in the future, more higher-income taxpayers are interested in Roth accounts.
When Roth IRAs were introduced by the Taxpayer Relief Act of 1997, there were income restrictions on the provision to convert traditional IRA assets to a Roth IRA. Specifically, Roth IRA conversions were limited to taxpayers with adjusted gross income (AGI) under $100,000.
In 2006, tax legislation signed into law (The Tax Increase and Prevention Reconciliation Act of 2005) repealed this restriction. As a result, beginning in 2010, the law opened the doors for all taxpayers – regardless of income – to take advantage of a Roth IRA conversion.
However, income limitations on who can contribute to a Roth IRA remain.* This dynamic created a path for some higher-income taxpayers to effectively contribute to a Roth IRA regardless of their income level, in a manner regarded as the “backdoor Roth strategy.” The strategy is a two-step process of making an after-tax (i.e., non-deductible) contribution to a Traditional IRA, and then subsequently converting the contribution to a Roth IRA.
While there are restrictions based on income on who can deduct a traditional IRA contribution, anyone with earned income (or a spouse of a worker with earned income) can make a non-deductible IRA contribution. Since the traditional IRA contribution is made with after-tax dollars, the contribution is not taxed when those funds are converted to a Roth IRA.
It is important to note there are some potential mistakes to be avoided when executing this strategy.
*For 2024, Roth contributions are eligible for those with modified AGI less than $146,000 (single) or $230,000 (married/filing jointly); phaseouts apply if modified AGI is $146,000–$160,999 (single) or $230,000–$239,999 (married/filing jointly).
Do you hold other traditional IRA funds not being converted?
When considering the backdoor Roth strategy, a critical first step is to be aware of the “pro-rata rule,” which applies when calculating the taxes on a Roth IRA conversion. A taxpayer must aggregate all IRA holdings (including SEP and SIMPLE accounts) to determine the percentage of pretax and after-tax holdings across all IRAs. For each dollar converted to a Roth IRA, a pro-rata proportion of pretax and after-tax funds will be considered for tax purposes. That is, a taxpayer owning a mix of pretax and after-tax IRA funds cannot convert only the after-tax portion to a Roth IRA.
For example, consider an individual’s account balance of IRAs that consists of 90% pretax funds and 10% after-tax funds. For each dollar converted to a Roth, 90 cents would be reported as ordinary income on their tax return and 10 cents would be non-taxable. Therefore, a backdoor Roth strategy is generally not recommended for those who hold IRAs with pretax funds that they do not want to convert to a Roth IRA (and owe taxes). Those holding retirement funds in non-IRAs such as 401(k)s or 403(b)s do not have to worry about this pro-rata rule since it only applies to IRAs. For them, a backdoor Roth strategy may be an appealing option depending on the specific circumstances.
Is there a way to avoid the pro-rata rule?
For participants in an employer-sponsored plan like a 401(k) who are interested in executing a backdoor Roth contribution, the answer is yes, assuming the plan will allow transfers into the plan. The first step is to transfer existing pre-tax IRA funds into the employer plan like a 401(k). As long as the taxpayer does not hold any pre-tax IRA funds at the end of the year, a backdoor Roth contribution could be executed without having to worry about the pro-rata rule. However, one must consider other factors when transferring retirement savings from an IRA to an employer retirement plan. For example, what type of investment options are available within the employer retirement plan? Transferring an IRA into an employer retirement plan may not be the best course of action depending on the circumstances.
Make sure tax forms are properly completed
If tax reporting on a backdoor Roth IRA contribution is not done correctly, it may be viewed by the IRS as a taxable IRA distribution instead of a non-taxable transaction. The key piece of reporting is IRS form 8606, Nondeductible IRAs.
Remember that the backdoor Roth strategy is a two-part process including:
- Making a nondeductible contribution into an IRA
- Converting that contribution to a Roth IRA
Taxpayers making a backdoor Roth IRA contribution will need to complete Part I of the form, which tracks any nondeductible contributions into an IRA (step 1). And then complete Part II of the form, which reports a conversion to a Roth IRA (step 2). Failure to complete form 8606 may lead to unnecessary taxes or a penalty.
Consult with a tax professional
With the prospect of higher tax rates on the horizon to address growing federal budget deficits, interest in Roth accounts which can provide tax-free income has surged.** For those at higher income levels, funding a Roth IRA using the backdoor strategy may be a way to help mitigate the risk of higher taxes in the future. However, given some of the complexities in the rules and tax reporting, it is advisable to consult with a tax professional if considering this strategy.
**For a distribution from a Roth IRA to be considered tax-free there are certain requirements that must be met. For more details consult IRS publication 590-B, Distributions from Individual Retirement Arrangements (IRAs).
For informational purposes only. Not an investment recommendation.
This information is not meant as tax or legal advice. Please consult with the appropriate tax or legal professional regarding your particular circumstances before making any investment decisions. Putnam does not provide tax or legal advice.