Pros and Cons of a Backdoor Roth IRA Conversion

By: Lisa M. Wood, CPA, MT - Director of Tax

Roth Individual Retirement Accounts (Roth IRAs) are an important planning and tax savings tool. If annual income is high enough to prevent Roth IRA contributions, a backdoor Roth IRA conversion can allow taxpayers to benefit from the tax advantages of a Roth IRA.

 A Roth IRA is an Individual Retirement Account set up with after-tax dollars. Contributions and earnings grow tax-free. Amounts can be withdrawn after the owner reaches age 59 ½ and the account has been open for five years. In addition, the withdrawal of contributions is usually allowed at any time, free of penalties or taxes. Roth IRAs do not have required minimum distributions (RMDs) like traditional IRAs, which makes this a very appealing strategy to those wishing to leave money to their heirs.

 The maximum contribution to a Roth IRA for 2022 is $6,000 ($7,000 if age 50 or over) provided there is at least that much earned income and total income falls within the Roth IRA contribution limits. In 2022, a single individual can contribute the full amount to a Roth IRA if income is below $129,000. Married individuals filing a joint return can contribute if income is below $204,000.

 If annual income disqualifies a Roth IRA contribution, taxpayers can utilize the backdoor Roth IRA conversion strategy. The first step is to open a traditional IRA and make a nondeductible contribution. There is no income threshold limitation on nondeductible contributions. File IRS Form 8606 Nondeductible IRAs to report the contribution each year. The second step is to immediately convert the traditional IRA into a Roth. This prevents the non-deductible contributions from accumulating investment gains, which would be subject to income tax.

 There are a couple of additional items to consider. A backdoor Roth IRA is characterized as a conversion, not a contribution, and an additional five-year rule applies. The funds in the converted Roth IRA cannot be accessed until the additional five-year period expires. If a backdoor Roth conversion is done each year, each conversion amount has its own five-year holding period. There are exceptions to this requirement if the withdrawal is made at age 59 ½ or older or due to disability or death.

 All traditional IRAs are considered as a single account when determining the taxes owed on distributions or conversions. Due to the pro-rata rule, this complicates backdoor Roth IRA contributions for people who already have balances in existing traditional IRAs. The pro-rata rule states that once money is contributed to an IRA, the portion that has already been taxed cannot be separated from the portion that has not been taxed. For example, assume 70% of the IRA accounts were made with pre-tax dollars and 30% were after-tax contributions. When the traditional IRA contribution is converted to a Roth IRA, 70% of the amount would be taxed in the conversion. The tax may be avoided if there is a 401(k) account available that allows IRAs to be “rolled in.” This retirement account is not considered in the pro-rata calculation.

 Even if some or all of the conversion is subject to tax, it may be worth paying the tax now to take advantage of future tax-free growth. There are many tax strategies that can be implemented to lower taxable income to reduce the tax rate on the conversion. For example, it is possible to harvest tax losses due to the current decline in stock market values. This can offset other gains, and thus result in lower taxable income and a lower tax rate.

 Backdoor Roth conversions have existed for several years. It is important to note that this tax strategy may not be available forever. In November 2021, the House of Representatives passed the Build Back Better Act (BBB). Included in the BBB were a number of retirement-related provisions including the elimination of the backdoor Roth IRA conversion. However, BBB has stalled in the Senate. It is feasible that some portions of the BBB may pass later this year. Bottom line: The backdoor Roth conversion is still a viable strategy and should be taken advantage of while available.

 Our experienced team at Buckingham Advisors is here to help. If you have questions related to your specific situation with IRAs, please reach out to one of our team members.

 Lisa M. Wood, CPA, Master of Taxation, is Director of Tax for Buckingham Advisors. She is involved in coordinating tax planning and compliance services, helping clients understand tax issues, and developing strategies to plan for their goals. Lisa’s experience includes working with several closely held businesses and helping generations of family members through succession planning.