Advising Clients on Using a Backdoor Roth IRA
More income is always better, but it does come with at least one drawback: The IRS does not allow high earners to contribute to a Roth IRA.
Single filers earning $139,000 or more and married filers earning $206,000 or more cannot contribute to a Roth IRA in 2020. This means your high earning clients are left without access to a potent tax-advantaged retirement savings vehicle unless they use the back door to get in.
"Advisors should encourage most of their clients that exceed the contribution income limits to open Roth IRAs through the backdoor process," says Victor Carlstrom, CEO of Vinacossa Enterprises Group based in New York. "The benefits of tax-free growth and withdrawals are exceedingly powerful, and the flexibility that comes with Roth IRAs opens multiple estate planning and retirement pathways."
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While the IRS limits Roth contributions, there aren't any restrictions on Roth conversions. The Tax Cuts and Jobs Act of 2017 states: "Although an individual with [adjusted growth income] exceeding certain limits is not permitted to make a contribution directly to a Roth IRA, the individual can make a contribution to a traditional IRA and convert the traditional IRA to a Roth IRA."
This is known as a backdoor Roth conversion. That's when someone makes a nondeductible contribution to a traditional IRA then converts it to a Roth IRA.
What is a Backdoor Roth?
Since anyone can contribute to a traditional IRA if they have earned income, regardless of their earning level, the backdoor Roth provides a way to slide more of your clients' retirement savings into tax-advantaged vehicles.
Clients who exceed the Roth IRA income limit likely won't be able to deduct traditional IRA contributions. Individual filers who have access to an employer-sponsored plan and earn $75,000 or more in 2020, or $124,000 or more for married filers, cannot deduct traditional IRA contributions. Since your client would have had to pay taxes on the conversion anyway, this is largely a moot point.
"You can make a nondeductible IRA contribution and immediately roll it over into a Roth," says David Desmarais, a certified public accountant and member of the American Institute of Certified Public Accountants' personal financial planning executive committee. "The reason why you roll it over immediately is if there are no earnings in the IRA before it is rolled into a Roth, there is no income to pick up on the conversion." Earnings would be taxable in the conversion.
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If your client doesn't plan on converting the traditional contribution immediately, you may want to advise him to keep the funds in cash "to avoid any earnings on the funds prior to the actual conversion," says Nick Defenthaler, a partner at Center for Financial Planning in Southfield, Michigan.
The Backdoor Roth IRA and the Aggregation Rule
Any existing pretax traditional IRA assets your client holds can make managing taxes a challenge with a backdoor Roth due to the aggregation rule.
Under the IRA aggregation rule, all traditional IRA accounts (excluding inherited IRAs) for an individual are treated as a single entity for tax purposes. This means if your client has multiple traditional IRAs that have untaxed earnings, whether from unrealized gains or prior deductible IRA contributions, she would have to aggregate all of the IRA assets when determining the amount of the taxable conversion, Desmarais says.
"For existing IRAs with large pretax balances, converting could mean a hefty tax bill because after-tax contributions are converted pro rata to the overall balance," says John Knolle, principal at Saranap Wealth Advisors in Walnut Creek, California.
For example, if your client has a $10,000 traditional IRA with $8,000 in pretax contributions and makes a $2,000 after-tax contribution, she wouldn't be able to convert the after-tax portion.
"This is known as the 'cream in the coffee' rule, meaning once after-tax dollars are mixed with pretax dollars, it's impossible to separate the two," Knolle says.
One way around the aggregation rule is to have your clients roll any pretax IRA assets into their current employer-sponsored plan, like a 401(k), assuming the plan allows roll-ins. Since employer plans are not aggregated, this would prevent the pretax assets from being included in the conversion.
This means the reverse -- moving funds from an employer plan to an IRA -- would have the opposite effect.
For this reason, Timothy Wyman, a managing partner at Center for Financial Planning in Southfield, Michigan, says to be careful doing backdoor conversions for clients entering retirement.
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If you help your client do a backdoor conversion in January, then the client retires in July and rolls his 401(k) into an IRA for you to manage, your client will run into "the aggregation rule," he says. "That will likely result in tax associated with the backdoor conversion you completed earlier in the year," he adds. In this situation, he advises delaying the 401(k) rollover until a new tax year.
Steps to Safely Do a Backdoor Roth Conversion
To avoid adverse tax consequences for your clients, follow these steps to do a backdoor Roth conversion:
1. Roll any preexisting pretax traditional IRA balances into an employer-sponsored plan if available.
2. Open a traditional IRA or use a newly-emptied one to make a nondeductible traditional IRA contribution.
3. Immediately convert the traditional IRA contribution to a Roth IRA, or keep the funds in cash until the conversion is made.
As always, you should encourage your clients to retain the services of a tax professional, Carlstrom says.
For backdoor Roths, the tax preparer will need IRS Tax Form 8606 to properly manage the client's taxes.
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