How to Do a Back-Door Roth Conversion

One retirement planning technique, unitized by high net worth families is what’s commonly referred to as a ‘backdoor Roth IRA.” 

Without getting too complicated, basically you put money in a traditional IRA, convert your contributed funds into a Roth IRA, pay some taxes and you're done. Even though you didn’t qualify to contribute to a Roth, you get to go in the back door anyway, no matter what your income.

That's good news, because your money grows tax-free — and that's a pretty sweet perk when it comes time to take your money out in retirement.

Many high-income earners believe that they can’t contribute to a Roth IRA because they make too much money and/or because they participate in a company 401k plan. But, there’s actually a work around. While direct contributions to a Roth IRA are limited to taxpayers with income in excess of $144,000 ($214,000 for married taxpayers, 2020), those whose income exceeds these amounts may make annual contributions to a non-deductible traditional IRA and then convert those amounts over to a Roth IRA.

You can also use this strategy to roll-over an existing Traditional IRA, but in this article I’m going to assume you earn too much to contribute to a ROTH and you’re covered by a retirement plan at work, but you still want to fund your ROTH.

Let’s first start with a fairly easy three step process. But, make sure you read to the end. It can get a bit complicated. 

The Three Step Process

Step 1: Fund a new non-deductible traditional IRA

We can help you set-up an IRA and then you can make a non-deductible contribution to the Traditional IRA of up to $6,000 (or more depending on age). You don’t get a tax deduction on the amounts contributed to the traditional IRA. 

Step 2: File Form 8606

You’ll need to file IRS form 8606 for the tax year in which you make non-deductible IRA contributions. The form can be found here. If you’re a client, we can help you with filing the form.

Step 3: Convert the non-deductible traditional IRA funds to a Roth IRA 

In 2010, the limitations on Roth IRA conversions, which previously restricted Roth IRA conversions for high-income earners, were removed. That means it’s a fairly recent strategy and one of the reasons more people don’t know about it. 

The Complication 

Here is where it gets slightly more complicated. If you have other existing traditional IRAs, then the tax treatment must take into account those existing IRA funds when undertaking a conversion (including SEPs and SIMPLE IRAs). 

If the only IRA you have is the non-deductible IRA, then the conversion is easy because you convert the entire non-deductible IRA amount over to Roth with no tax on the conversion. Remember, you didn’t get a deduction into the non-deductible traditional IRA so there is no tax to apply on conversions. 

On the other hand, if you have an existing IRA with say $100,000 in it and you have $5,000 in non-deductible traditional IRA contributions in another account that you wish to convert to Roth, then the IRS requires you to covert over your IRA funds in equal parts deductible ($100K bucket) and non-deductible amounts (the new $5K) based on the money you have in all traditional IRAs. 

So, if you wanted to convert $10,000, then you’d have to convert $9,500 (95%) of your deductible bucket, which portion of conversion is subject to tax, and $500 of your non-deductible bucket, which isn’t subject to tax once converted. Consequently, the “back door” Roth IRA isn’t as well suited when you have existing traditional IRAs that contain deductible contributions and earnings from those sums.

There are workarounds, but I’d recommend contacting your CPA or a financial advisor if you’re at this point and need a workaround. 

But, here’s the bottom line. Roth IRAs can be established and funded by high-income earners.