The Backdoor Roth

Traditional IRA vs Roth IRA

The traditional Individual Retirement Account (IRA) allows U.S. taxpayers to set aside savings for retirement before tax—the amount contributed reduces income and thereby reduces taxes up front, in the year of the contribution. No taxes are due on earnings, interest, or realized capital gains while the account grows. This is known as “tax-deferred buildup.” Taxes are not due until the money is withdrawn. However, distributions are considered ordinary income and are subject to ordinary income tax rates, which are typically higher than the rates applied to long-term capital gains (currently 15% or 20%). 

The Roth IRA does not reduce income, or taxes, immediately. Taxes have already been paid on money contributed to a Roth. Like the traditional IRA, while the account grows there are no taxes due on earnings, interest, or realized capital gains. However, unlike with the traditional IRA, no tax is due when money is withdrawn. Ever. This is known as “tax-free buildup,” and can be more valuable than the traditional IRA’s “tax-deferred buildup.”

Most people have a retirement plan through their work, most commonly a 401k plan. For most people, it makes sense to contribute to their employer-sponsored retirement plan before considering whether to also contribute to a traditional IRA or a Roth IRA. The reasons to prioritize an employer-sponsored plan are:

1. To take advantage of any matching contributions offered by the employer
2. To take advantage of the higher contribution limits ($19,500 in 2021, or $26,000 if over 50)
3. To take advantage of the fact that there are no income limits on the deductibility of contributions

Compared to a 401k plan (or other similar plans, such as a 403b plan), an IRA is not nearly as attractive for most people. The contribution limit is only $6,000 in 2021 ($7,000 if over 50). And people with higher incomes may not be able to deduct their IRA contributions from income if they are covered by a plan through their work, which kills the most attractive feature. However, Individuals who are not covered by an employer-sponsored retirement plan may make tax-deductible contributions to an IRA regardless of income.  

For 2021, single taxpayers who are covered by an employer plan start to have the deductibility of IRA contributions reduced at an income of only $65,000 and it disappears completely at $75,000. IRAs are always owned by individuals, not jointly by couples. For married taxpayers filing joint returns, the circumstances of each individual spouse matter, as well as their joint income. The deductibility limits for married taxpayers filing jointly also depend on whether they or their spouse have an employer-sponsored retirement plan. For a spouse covered by an employer plan, the deductibility of a traditional IRA contribution starts to phase-out at a joint income of $105,000 and disappears at $125,000 (in 2021). For a spouse not covered by an employer-sponsored plan but who has a spouse who is covered, deductibility phase-out starts at a joint income of $198,000 and disappears at $208,000 (in 2021). 

Contributions to Roth IRAs are not deductible, of course, but there are income limits on making Roth IRA contributions. Overall contribution limits are the same as for traditional IRAs: $6,000 in 2021 ($7,000 if over 50). Single taxpayers start to have their contribution limits reduced at an income of $125,00, and it is zeroed out at $140,000 (in 2021). Taxpayers who are married filing jointly have phase-out beginning at $198,000 and it is zeroed out at $208,000. 

Subject to these limitations, non-working spouses can contribute to either type of IRA as long as their spouse has enough income to cover their own and their spouse’s contributions. These “spousal IRAs” may be the one niche which no other retirement plan can cover. 

If you are self-employed, a solo 401k plan has the same high contribution limits as an employer-sponsored plan, so for most self-employed people, the solo 401k is more attractive than contributing to an IRA. Other retirement plan options for the self-employed include the SEP IRA, the Simple IRA, and the Keough. All of these allow for far higher contributions than the IRA. 

Since 2001 when tax laws were changed to allow Roth 401k plans, more and more employers are offering the choice whether to contribute to a traditional 401k or a Roth 401k. 

There are some important advantages to a Roth IRA (or Roth 401k) over a traditional IRA (or 401k).  Roth IRA money is not subject to RMDs, but Roth 401k money is.  Therefore, it is usually a good idea to roll over money from a Roth 401k into a Roth IRA to provide maximum flexibility in using the money. Also, because Roth money must be held for at least five years before it can be withdrawn, it is a good idea to get the five-year clock started early. Generally speaking, it is optimal to draw upon tax-deferred money in retirement first (such as in a traditional IRA or 401k) before drawing upon tax-free money, such as a Roth IRA or HSA.  You want to let that tax-free money grow as long as possible before you have to use it.  Also, if you leave a Roth IRA to your heirs, it will be tax-free to them as well.   

Traditional or Roth:  Which is Better?

Deciding which to contribute to, a traditional or a Roth IRA (or 401k), is simply a matter of comparing your current marginal tax rate with your expected future marginal tax rate (MTR). Your marginal tax rate is the rate applied to your last dollar of income. It is also commonly known as your “tax bracket.” If your current MTR is higher than your expected MTR in retirement (when you will be withdrawing money from your IRA that will be subject to ordinary income taxes starting at age 72), then reducing your taxes (and income) now with a traditional IRA is the way to go. If your current MTR is lower than you believe it will be in retirement, then a Roth is the more attractive choice. It’s a matter of “tax rate arbitrage.”  

For many people with substantial retirement assets, it is not unreasonable to project that the accumulated growth in those assets will result in very large required minimum distributions (RMDs) starting at age 72, with the result that taxable income may be higher in retirement than it was even during peak working years.  See our article, “Is Your IRA a Ticking Tax Bomb?”  

Of course, forecasting your future tax bracket is neither simple nor straightforward. Future RMDs will depend heavily on market rates of return between now and then. Likewise, taxable income from taxable savings will depend on future interest rates and dividend yields. On top of these levels of uncertainty is the wildcard of possible future changes in federal (and state and local) tax rates. It is a reasonable bet that tax rates will increase in the years ahead.

The conventional wisdom is that most people have a low tax rates early in their career, which rise as they earn a higher income later on, and then drop down after retirement. Assuming this pattern holds, making after-tax Roth contributions during the early years, then switching over to pre-tax regular contributions, would be optimal for most people. 

After retirement, IRA contributions can still be made as long as there is earned income enough to cover them (either your own or your spouse’s income). Presumably, if income has come down significantly, Roth IRA contributions may be more attractive than traditional IRA contributions.

Furthermore, the “gap years” after retirement but before the onset of RMDs from IRAs are often prime years for “Roth conversions.”  This involves moving money from a traditional IRA to a Roth IRA, typically over a period of years. These distributions are considered taxable income, so taxes must be paid. However, if your tax rate is lower than it will be after age 72 when RMDs begin, Roth conversions can save a bundle on expected lifetime taxes. 

The Backdoor Roth

Let’s assume that you have decided that contributing to a Roth IRA is optimal for you because your income and MTR are below what you expect after age 72. If you have the option to contribute to a Roth 401k, that typically becomes the logical first choice because of the high contribution limits. However, let’s say that you do not have that option. Then, contributing to a Roth IRA may make sense. But what if your income is higher than the allowed income limit for Roth contributions?  

This is when a “backdoor Roth” may be tempting. There is no maximum income for making contributions to a traditional IRA. Contributions at incomes above the limits for making deductible contributions are considered after-tax (non-deductible) contributions. An IRA can have both deductible and non-deductible contributions. 

However, making non-deductible contributions to a traditional IRA is not likely to be a very tax-smart strategy over the long-term. Yes, you get the benefit of a tax-deferred buildup, but without the initial benefit of a tax-deduction, many investors would be better of just putting the money into a taxable brokerage account where long-term capital gains are taxed at a preferential rate (currently 15% or 20%). Gains are taxed at ordinary income rates when they are taken out of a traditional IRA.

But what if you transferred those non-deductible contributions out of the traditional IRA and into a Roth IRA?  Since taxes were already paid on the non-deductible contributions, they are not taxed when withdrawn or transferred to a Roth. This is the basic idea behind a “backdoor Roth.”  If you make too much money to come in through the front door with regular Roth contributions, maybe you can come in the “backdoor.”    

However, there are several potential problems with this scenario. First and foremost, the IRS “pro-rata rule” requires that any distributions out of a taxpayer’s IRA money is considered a “pro-rata” distribution of deductible and non-deductible contributions. Once these are mixed, there is (almost) no going back. Putting non-deductible contributions into your IRA is like adding cream to your coffee. You can’t just transfer the “cream” of non-deductible contributions to a Roth IRA. It’s doesn’t matter if you kept your non-deductible contributions in a separate account. All IRA money is the same to the IRS and the pro-rata rule must be applied to all IRA money. 

To make matters worse, any gains you earn on those non-deductible contributions are treated as deductible contributions. You will have to pay ordinary income tax rates on the gains.

The only way to make this work cleanly is if you have very little money in your IRA accounts, or if you don’t even have an IRA account at all. Then each year you can transfer 100% of your traditional IRA money over to Roth (including any non-deductible contributions you make), paying whatever tax is owed on the little bit that may be deductible (including any gains on non-deductible contributions). 

Who is likely to have no money at all in a traditional IRA? Perhaps someone who has only saved for retirement within employer-sponsored plans. Or perhaps someone who has already converted all of their traditional IRA money over to a Roth IRA. As mentioned above, a series of partial “Roth conversions” from traditional IRA accounts may be optimal during the “gap years” immediately after retirement. Once all the traditional IRA money has been converted to a Roth IRA, it may be logical to consider backdoor Roth contributions after that as long as you have enough earned income to cover the contributions.   

Many people have quite a lot of money in their traditional IRA accounts. One way to get money out of IRA accounts is to do a “reverse rollover,” whereby you take the money in your IRA accounts and put it into an employer’s 401k plan. However, not all plans allow this. One major advantage of doing a reverse rollover is that it may be possible to reverse rollover just deductible IRA money and leave any non-deductible money behind (as long as the contributing IRA custodian has the necessary accounting records and the receiving 401k plan allows it). Thus, the reverse rollover may be the only way that you can separate deductible IRA money from non-deductible IRA money, kind of like a centrifuge separating the coffee from the cream.

Another advantage of doing a reverse rollover is that it would allow you to delay taking RMDs past age 72 if you are still working. IRS rules do not require RMDs out of a company-sponsored retirement plan for a non-controlling employee (who owns less than 5%) until they have stopped working. 

Really, a “backdoor Roth” is simply the combination of making a non-deductible contribution to your traditional IRA and then quickly doing a Roth conversion of that money. You will need to file a Form 8606 to tell the IRS that you put after-tax (non-deductible) money into an IRA. You also need to be sure to tell your tax-preparer, and be aware that many rudimentary tax programs do not know how to handle this situation.              

If you expect your future tax bracket to be higher than your current tax bracket, and you do not have any money already in an IRA, then a backdoor Roth can make sense. But there are few people in this situation. And most of them may be better off simply contributing to a Roth retirement plan from the get-go, such as a Roth 401k (if employed by a company that offers one), or a Roth solo 401k (if self-employed). For one thing, it is much cleaner and simpler. For another, the contribution limits are much higher. For many people, making annual backdoor Roth contributions of $6,000 or $7,000 per year is not going to move the needle much. 

The Mega Backdoor Roth

If you have quite a lot of extra cash flow, the “Mega Backdoor Roth” may make sense for you. In this case, the money for funding a Roth comes from non-deductible contributions to an employer-sponsored retirement plan. But there are several requirements:

• Your employer 401k or profit-sharing plan must allow after-tax, non-Roth contributions.
• The plan must also permit in-plan rollovers to a dedicated Roth account (a Roth 401k) or allow in-service non-hardship withdrawals.
• Separate plan accounting of pre-tax vs after-tax contributions. The pro rata rule will apply unless the plan clearly separates pre- and post-tax contributions and earnings.

Here’s how it would work:

• You max out individual pre-tax 401k contributions or after-tax Roth 401k contributions: $19,500 in 2021 or $26,000 if 50+.
• Then, you make after-tax contributions up to the annual maximum (combined employee and employer). In 2021, this is $58,000 ($64,500 if 50+). If your employer offers matching or profit-sharing contributions, this will reduce how much of the $58,000 (or $64,500) limit is left for you to contribute, since the limit is the sum of both employer and employee contributions.
• You then elect an in-plan Roth 401k rollover/conversion (if your plan has one and allows this) or you can roll the after-tax contributions into a Roth IRA, paying tax on the earnings, if any.

It is important to be aware that the IRS has various testing requirements that prevent plans from favoring “highly compensated employees (HCEs).” If only HCEs are making after-tax contributions (other than to a Roth 401k), it may cause the plan to fail the tests and some or all of the non-deductible contributions may have to be returned to the participant. Many plans do not allow allow non-deductible contributions for this reason.

The mega backdoor Roth is one way to super-charge your retirement savings, since it allows you to sock away up to an extra $38,500 per year if you are over 50. If you expect that your tax bracket will be higher at age 72 than it is now, and your circumstances make it feasible, this is likely to be an optimal strategy. Even if you do not think your tax bracket will increase in the future, sheltering after-tax money from any further taxation is quite valuable compared to, say, putting it into a taxable brokerage account. However, it is important to get the money into a Roth account quickly in order to shelter the growth. Any growth in the non-deductible contributions is subject to tax at ordinary rates. 

Summary and Conclusions

• Deciding between whether to contribute to a traditional IRA or 401k or a Roth IRA or 401k is simply a matter of determining if your current tax bracket is higher or lower than it will be after age 72.  If it will be lower later, then stick with traditional.  If it will be higher, then go with Roth.
• A backdoor Roth is simply the combination of making non-deductible contributions to a regular IRA and then quickly converting that money to a Roth IRA. However, because of the IRS “pro-rata rule,” it only works if there is no money in traditional IRAs.  
• A mega backdoor Roth takes advantage of the little-known fact that IRS rules allow relatively large non-deductible contributions to employer-sponsored retirement plans on top of the amounts that are deductible.  The key (other than having a lot of extra cash to invest) is having a 401k plan that allows 1) after-tax, non-Roth contributions, 2) in-plan rollovers to a dedicated Roth account (a Roth 401k) or in-service non-hardship withdrawals to a Roth IRA, and 3) separate plan accounting of pre-tax vs after-tax contributions.