Backdoor Roth IRA conversions have been a technique I have employed with clients since I became an advisor. However, many people hear this phrase “Backdoor Roth IRA” and are not quite sure what it means or how to open this type of account. (Please Note: you can’t just go and open a Backdoor Roth IRA as it is a strategy rather than a type of account)

Before we get into the Backdoor Roth IRA discussion, here are a few of the basics of the Individual Retirement Account (IRA). There are two types of IRAs where an investor could save, their Traditional IRA or Roth IRA. The Traditional IRA is an account contributed to with pre-tax dollars while Roth IRA contributions are made with post-tax dollars. In other words, with a Traditional IRA you are deferring your taxes until you hit your required minimum distribution age where you would have to take a portion of your account out every year based on the actuarial tables. With a Roth IRA, you are locked in your current tax bracket at today’s income tax rates and can take distributions out tax-free. (There are some rules regarding earnings if taken out before certain timeframes. Please find some of those rules here.)

However, there are a few caveats for both Traditional and Roth IRA contributions. Traditional IRAs are only deductible under certain circumstances based on your income and if you/your spouse (if applicable) are covered or not by a retirement plan through work. Please see the links to the IRS website here:

IRA Deduction if you ARE Covered by a Retirement Plan at Work 2023

IRA Deduction if you ARE Not Covered by a Retirement Plan at Work 2023

If you and your spouse are not covered by a retirement plan through work, then your Traditional IRA contributions are fully deductible.

As for Roth IRAs, there are certain income limitations. Please find them here.

For those high-income earners who cannot contribute to a Roth IRA directly, they can still contribute to a Traditional IRA, but the contributions would not be deductible on their Form 1040. Instead, they would have “cost basis” in their Traditional IRAs which is reported on tax Form 8606. Tracking your cost basis is very important because if you don’t do it, you may inadvertently pay taxes on your nondeductible Traditional IRA contributions. Since you have already paid taxes on these funds, you would be getting double taxed in this instance.

So, let’s say you made a $6,000 Traditional IRA contribution, which was not deductible and wanted to convert it to a Roth IRA. If you decide to convert $6,000, you really need to be aware of any other types of IRAs you may have such as other Traditional IRAs, SEP IRAs, or SIMPLE IRAs. You cannot just convert a piece of one IRA and not the others (Roth IRAs are not included in the calculation). Therefore, before converting the Traditional to a Roth, check to see if your other Traditional/SEP/SIMPLE IRAs had any value as of 12/31 of the prior year (This is very important). Investors with the best intentions get hit with taxes on these conversions as they are not aware that the formula considers the other IRAs you may have. Please check Form 5498 for each account before converting the funds to make sure you are aware of the values reported to the Internal Revenue Service.

If you do not have any other Traditional/SEP/SIMPLE IRAs outstanding and do the conversion, your funds will be converted from non-deductible (after-tax) contributions to a Roth IRA. The $6,000 conversion would be reported on Form 1099-R as a distribution from your Traditional IRA and you will need to report the conversion on Form 8606. This will complete the backdoor conversion from a nondeductible Traditional IRA to a Roth IRA and your funds will grow tax-free going forward. This strategy is known as the Backdoor Roth IRA Conversion.

Before I leave you, I wanted to give two tips on Backdoor Roth Conversions:

Tip #1: After you make the nondeductible Traditional IRA contribution, convert it to the Roth IRA immediately so you don’t pay tax on any earnings in the Traditional IRA. (Please be aware of the aforementioned Traditional/SEP/SIMPLE IRA values before converting).

Tip #2: If you do have Traditional/SEP/SIMPLE IRAs, it isn’t the end of the world. You may want to consider rolling them into your 401(k) plan through work if possible. Since the 401(k) is a different type of plan, it would not have a tax impact. If you are a solo business owner (which can include your spouse), consider opening an Individual 401(k) and rolling the funds in there. Please beware that once assets hit $250,000 in individual 401(k)s, there will be Form 5500 filing requirements.

I hope you found this blog helpful. Always feel free to contact me with questions.

Michael Sherman, CPA, CFP®, CPFA, CDFA®
OWNER
Sherman Wealth Solutions LLC
Michael.Sherman@shermanws.com
O  980.350.0170
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www.shermanws.com

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