What's a Backdoor Roth Conversion?

Yesterday, I posted this article that reflected on my first year as a personal finance blogger. It has been an incredible journey thus far but I am ready to up the ante this year and dive into more complex and hopefully even more relevant personal finance topics for you all.

Today I am tacking Backdoor Roth Conversions! This is a planning concept that comes up time and time again in my client conversations and has been a frequently asked questions by my followers. This post will explain the basic concept of a Backdoor Roth Conversion, help you identify if you can use or benefit from the strategy and will wrap up by walking through the process step-by-step.

This article is meant to be informational and helpful but should not be considered a recommendation. The only recommendation you will get from me is to work with a professional before adopting this or other financial planning strategies.

The Basics

Before I dig in and begin explaining this unique financial planning strategy, it’s important to level set and review some basic personal finance terms.

Traditional IRA – a retirement investment account that is funded with pre-tax dollars. In the year of contribution, the account owner receives an income tax deduction if their income falls below the annual income limitations (see below). Dollars in this account grow tax-deferred and are later taxed when distributed in retirement at the account owner’s marginal tax rate.

Traditional IRA income limits in 2019 and 2020

Table from www.nerdwallet.com

Roth IRA – a retirement investment account that is funded with after-tax dollars. At the time of the contribution, the account owner does not receive a tax deduction. Dollars in this account grow tax-free. When funds are distributed in retirement, the account owner is not taxed because they were already taxed at the time of the contribution. To contribute directly into a Roth IRA, the account holder’s income must fall below a certain threshold (see below).

Roth IRA income & contribution limits for 2019 and 2020

Table from www.nerdwallet.com

Tax Deduction – a method to reduce a taxpayer’s taxable income and tax liability.

Non-Deductible Contribution – a contribution that is made into a Traditional IRA that cannot be used as a tax deduction. The primary reason the contribution does not qualify as a tax deduction is because the account holder makes too much income to qualify as a deduction. See the table above under Traditional IRA for the income limits. In other words, you can make the contribution but it cannot be used to offset taxable income.

If you want to read more on traditional and Roth IRA’s, click here to read a previous post that covers both Traditional and Roth IRAs in greater detail and discusses taxable investment accounts.

Eligibility

Before sharing the logistics of a Backdoor Roth Conversion process, its important to understand who is eligible for this strategy and who is not eligible. They way I talk about this topic with clients, there are three eligibility “tests” to pass.

1. Income Test

This is the easiest “test” to identify whether or not you pass. For starters, if you make less than $122,000 as a single tax filer or $1930,000 as a married tax filer in 2019, life just become much simpler. At this level of income, you have the ability to make direct contributions into a Roth IRA and can avoid the backdoor strategy all together.

If you make more than the amounts noted above, you pass this part portion of the exam and may be a candidate for a Backdoor Roth Conversions. At the higher income level, you are prohibited from making contributions directly into a Roth IRA. The only other option to fund a after-tax retirement account (outside of a Roth 401(k)) is to make contributions through the backdoor…

Get it? Backdoor Roth conversion.

2. Retirement Accounts Test

The next test to pass is based on your existing retirement accounts. For the backdoor Roth to be the most tax efficient, you cannot have an existing traditional IRA opened and funded. I will get to the reasoning in a minute. Please don’t confuse a 401(k) with a Traditional IRA, they are two different and unique account types. You, as the taxpayer, can have an open and funded 401(k) but having an open and funded Traditional IRA can muddy the tax waters and tax efficiency of this strategy.

For those of you who want to understand why having an existing Traditional IRA creates tax drag, I recommend reading this article. It does a great job of summarizing what happens if you use the Backdoor Roth strategy and already have deductible contributions. For those of you who don’t care or don’t want their mind to end up in a pretzel, I encourage you to keep reading…

What happens if you have a Traditional IRA but still want to pursue the Backdoor Roth conversion? If you find yourself in this situation, you have a few options to make yourself eligible once again for a Backdoor Roth:

  1. Rollover an old 401(k) into your new 401(k) and not a Traditional IRA.
  2. Reach out to your Human Resources team to find out if you can rollover your current IRA (formerly an old 401(k)) into your current 401(k).
  3. Convert existing IRA into a Roth IRA and pay the distribution taxes. Per the beginning of this article, distributions will be taxed at your current marginal tax bracket.

I’ll say this again, Backdoor Roth Conversions are a complex planning strategy and should not be implemented lightly. Before acting on the items above, please reach out to a professional to ensure you understand the full tax implications of your actions and confirm that those actions are in alignment with your larger financial goals.

3. Savings Ability Test

The third eligibility test is savings ability. By that I mean, the backdoor Roth strategy is an advanced savings strategy and should only be used if your 401(k) or other employer retirement plan is max funded.

If you are not already maxing out your 401(k) but have additional money to save for retirement, put those extra funds into your 401(k). If after maxing out your 401(k) and your spouse’s 401(k) (if applicable) then you can consider using the Backdoor Roth strategy. As a reference point, in 2020 employees can contribute up to $19,500 ($6,500 catch up if over 50 years old) into their employer 401(k) and the contribution limit for IRAs is $6,000.

Sharing below what I call the “Savings Hierarchy” to illustrate which buckets to prioritize saving into first.

The Tax Play

If you passed the three eligibility test above, Congratulations! You are probably excited to get started and understand the logistics behind the conversion. I feel the excitement and can’t wait walk you through the process, but first we need to talk taxes. So fun, I know!

In the spirit of education, I think its super important to understand why taxpayers and investors use this strategy and why its valuable tool in your financial toolbelt.

The primary reason investors use a Backdoor Roth strategy is to create tax diversification in retirement. By diversification, I mean having a variety of tax “buckets” or accounts to choose from in retirement. Going back to the difference between Roth IRA and Traditional IRA, dollars in a Roth IRA will not be taxed in retirement while dollars in a Traditional IRA accounts will be taxed in retirement. Having tax diversification and multiple accounts to withdrawal funds in retirement to support living expenses and avoid additional income tax will be very appealing, trust me.

The other reason a Backdoor Roth strategy is so popular is that it allows teh taxpayer to take advantage of current tax rates. Today, we are in a period of historically low income tax rates. Where they will end up during our respective retirement years is completely unknown. Paying tax on contributions today in a lower income tax environment is very lucrative. If tax rates are higher for you in retirement and you make Roth contributions today, you win that tax bet every single time.

The devil you know is better than the devil you don’t know.

The Process

You made it! We are finally at the part where I walk you through the Backdoor Roth Conversion process. Sorry for boring you up until this point but this is all important information you should know and understand before moving forward. You have met all eligibility requirements and understand the the tax strategy behind the Backdoor Roth, now it’s time to get the accounts set-up and funded.

Step-By-Step

  1. Open a Traditional IRA with your custodian
  2. Make a non-deductible IRA contribution into the account up to the limit ($6,000 if under 50, $7,000 if over 50). Remember, non-deductible means you can make the contribution but you will not receive the tax deduction because you make too much money.
  3. Wait a few days then open a Roth IRA with your custodian.
  4. Instruct your custodian to move the funds in the Traditional IRA into the Roth IRA
  5. Invest the funds in the Roth IRA targeting long-term growth (remember you can’t use this account until you are 59.5 years old).
  6. Repeat each year. Once you have the two accounts established, you don’t need to keep opening new Traditional IRA and Roth IRAs each year.

Step five is super important. If you skipped past it when reading through the steps, go back and take a look. I’ll wait…

Investing the Backdoor Roth contributions is so important! I can’t tell you how many clients have come to me with their Backdoor Roth’s only to discover they are sitting in cash or a money market fund. This is such a missed opportunity. The purpose of these funds are to support retirement living which for some folks is decades from now. Let the time value of money work for you and invest those dollars!

If this is something you want to take advantage of in 2019, you are in luck and have until April 15, 2020, to make a 2019 Backdoor Roth contribution. And because we are already in 2020, you can also go ahead and make a 2020 contribution at the same time. If you don’t have the cash available today to fund both years, don’t worry. The 2020 funding deadline is April 15, 2021.

If you have any questions specific to the Backdoor Roth and if it makes sense for your personal sitaution, feel free to reach out!

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