For many Americans, saving for retirement is a top priority and ensuring that retirement savings accumulate in the most tax advantaged way is an important step in achieving the retirement of their dreams. For decades, Roth IRA accounts have provided a tax-free option for retirement savings and have accelerated the growth of retirement accounts for many families.
While Roth IRA accounts provide attractive tax benefits, there are income limits that restrict the ability of high-income families to contribute to these accounts, and although these income limits appear to eliminate the benefits of Roth IRAs for high-income families, there is an allowable way to work around the restrictions that has the potential to save hundreds of thousands of dollars in lifetime taxes. Welcome to the back-door Roth IRA strategy.
At a high level, the back-door Roth IRA strategy involves a two-step process where an individual makes a non-deductible contribution to a traditional IRA and then immediately converts the traditional IRA balance to a Roth account. While this process is simple in theory, there are multiple rules that are important to understand prior to engaging in a back-door Roth IRA strategy.
Tax Benefits of IRA Accounts:
To fully appreciate the back-door Roth IRA strategy, the first place to start is with a quick overview of the tax benefits of both traditional and Roth IRA accounts.
Traditional IRA Account: A traditional IRA account provides two primary tax benefits. The first is that the taxpayer is typically allowed to take a tax deduction at the time the contribution is made. In other words, the income used to make the contribution avoids being taxed and remains tax deferred until a later date.
The second tax benefit is that all investment income (interest, capital gains, dividends, etc.) within the traditional IRA account accumulates on a tax deferred basis as long as the funds remain in the account.
In exchange for the tax deduction on the amount contributed and the tax deferred growth, the taxpayer is required to pay tax on any amounts distributed out of the account in the future.
Since the amounts in traditional IRAs are tax deferred, the IRS has implemented required minimum distributions beginning at age 72. Required minimum distributions are mandatory withdrawals that are treated as taxable income to the taxpayer. This ensures the IRS begins receiving tax revenue from the account during the taxpayer’s lifetime.
Roth IRA Account: A Roth IRA account also provides two tax benefits; however unlike the traditional IRA, the tax benefits of a Roth IRA do not include a tax deduction for the initial contribution. Rather the two primary tax benefits of a Roth IRA are that the income within the Roth IRA account accumulates tax free and distributions from the Roth IRA to the taxpayer in the future are also tax free (as long as the Roth IRA withdrawal rules are followed).
An additional aspect of Roth IRAs is that they are not subject to required minimum distributions. This allows individuals with Roth IRAs to benefit from the tax-free accumulation of their accounts for their entire lifetime and beyond (inherited non-spousal Roth IRAs generally must be withdrawn within 10 years of the account owner’s death).
To summarize, both traditional IRAs and Roth IRAs provide two primary benefits. They both allow the investments within the accounts to grow without being taxed. The main difference is that a traditional IRA allows a tax deduction at the time of contribution but future withdrawals are taxed whereas a Roth IRA does not provide a deduction for the contribution but allows tax free withdrawals. The following graphic displays this concept.
Key Takeaway:
The primary difference between a traditional IRA and a Roth IRA is that a taxpayer making a Roth IRA contribution forgoes the tax deduction on the initial contribution in exchange for tax free distributions in retirement.
While many taxpayers are interested to know whether the benefits of a traditional IRA or a Roth IRA are more valuable, that question is irrelevant for many high-income taxpayers. The reason is that the benefits of both traditional and Roth IRAs are restricted when income exceeds certain thresholds. As a result, it is no longer a question of which benefit is greater; rather it is a question of how to receive any of the benefits at all.
Limits to IRA Tax Benefits:
Before covering what high-income taxpayers can do to receive the benefits of these accounts, it is important to understand the restrictions the IRS has put in place for IRA accounts. Some of the restrictions like contribution limits apply to all taxpayers, whereas others such as income limits only apply to high-income taxpayers.
- Traditional and Roth IRA Contribution Limit: There is a single contribution limit that applies on a combined basis to traditional and Roth IRAs. Since the limit is a combined limit, contributions to either a traditional or a Roth IRA are added together when applying the limit. The contribution limit for 2022 is the lesser of:
- $6,000 (plus an additional $1,000 catch-up contribution for those age 50 and over), or
- The taxpayer plus their spouse’s taxable compensation (i.e. wages, salaries, commissions, tips, bonuses, or net income from self-employment).
- Roth IRA Income Limit: Direct Roth IRA contributions are only allowed for individuals based on the following income thresholds:
- Married individuals who have income over $204,000 (2022) and single individuals who have income over $129,000 (2022) begin to have their full Roth IRA contribution limit phased out.
- Married individuals who have income over $214,000 (2022) and single individuals who have income over $144,000 (2022) cannot make ANY direct Roth IRA contributions.
- Traditional IRA Income Limit: Traditional IRA contributions can be made regardless of income; however the deductibility of the contribution is subject to the following income thresholds.
- A married taxpayer covered by a retirement plan at work is restricted from deducting their full traditional IRA contribution if their income exceeds $109,000 ($68,000 for single filing status).
- A married taxpayer who is not covered by a retirement plan at work, but who has a spouse that is covered by a retirement plan at work will see the allowable deduction for a traditional IRA contribution reduced if their income exceeds $204,000 (2022).
- Individuals who neither are covered by a retirement plan at work nor have a spouse covered by a retirement plan at work are allowed to deduct their traditional IRA contribution regardless of income level.
- IMPORTANT POINT: One of the key points to the back-door Roth IRA strategy is that the income limits impacting a traditional IRA contribution only apply to whether the traditional IRA contribution is DEDUCTIBLE. They do not eliminate the ability to make a non-deductible traditional IRA contribution. In other words, a traditional IRA contribution is allowed regardless of income but the associated tax deduction may be disallowed if income is too high.
Key Takeaway:
Income limits restrict high-income taxpayers from most of the benefits of traditional and Roth IRA accounts.
Given the IRS limits the ability to deduct traditional IRA contributions as well as make direct Roth IRA contributions, high-income families must get creative if they intend to benefit from making contributions to IRA accounts. The back-door Roth IRA contribution is the most effective solution to this problem.
Back-door Roth IRA Contributions:
A back-door Roth IRA contribution begins when a high-income individual makes a non-deductible contribution to a traditional IRA. Since the income limits for traditional IRAs only apply to whether the contribution is deductible, anyone regardless of income can make a non-deductible contribution to their traditional IRA.
Once the contribution to the traditional IRA is complete, the next step is to convert the balance in the traditional IRA to the individual’s Roth IRA. Once again there are no income limits on Roth conversions; so the conversion from the traditional IRA to the Roth IRA can occur regardless of income level.
NOTE: An important distinction is that a Roth conversion and a Roth contribution are different. Therefore, the income limits that apply to a Roth IRA contribution do not apply to a Roth conversion.
It is important to point out that the non-deductible contribution to the traditional IRA results in tax basis equal to the contribution itself. So as long as there has been no gain or loss between the time of the non-deductible contribution to the traditional IRA and the conversion to the Roth IRA, there will be no tax due on the Roth conversion since the entire amount converted represents after-tax dollars (see Pro-Rata Rule Below for exception).
After the Roth conversion is complete, the high-income individual has completed a back-door Roth IRA contribution and the funds are sitting in a Roth IRA where they can grow tax free for life. The process is demonstrated in the following graphic:
Value of Back-Door Roth IRA Contributions:
To demonstrate the value of a back-door Roth IRA strategy, consider the following example. Assume a married couple each makes the maximum 2022 back-door Roth IRA contribution of $6,000. Together they will be able to contribute a total of $12,000.
Given Roth IRAs are tax-free accounts, they are often the last accounts to be drawn from in retirement. Accordingly, even for middle aged individuals, it will likely be 40+ years before they draw on the account. Since assets in a Roth IRA typically have the ability to compound for decades, we will assume the back-door Roth IRA contribution will not be withdrawn for 40 years.
Assuming a 7% rate of return over 40 years, the $12,000 contribution would grow to $179,693 on a completely tax-free basis. In contrast, if the back-door Roth IRA contribution had not been made and the funds were invested in a taxable account, the sale of the investments at the end of 40 years would have resulted in $167,693 of capital gain ($179,693 less the $12,000 original contribution).
By having the assets in a tax-free account, the couple in our example would save over $33,539 in taxes (assuming 15% Fed + 5% State tax rates) as demonstrated in the following calculation.
As the example demonstrates, the taxes that can be saved over the course of a lifetime from a single year of back-door Roth IRA contributions is substantial. The table above shows the tax savings of a single $12,000 contribution after 40 years while the following graph shows the tax savings at each point in the 40-year period.
While the value of a single year of back-door Roth IRA contributions is compelling, individuals can make back-door Roth IRA contributions each year. When the future tax savings of recurring annual back-door Roth contributions are realized, the impact of the back-door Roth strategy becomes even more powerful.
The following chart shows the total account value and tax savings achieved if annual $12,000 back-door Roth IRA contributions are made for the full 40-year period.
As demonstrated by the chart above, annual back-door Roth IRA contributions for a married couple results in $416,665 of tax savings and a total balance of $2,563,315 at the end of 40 years! Those are substantial tax savings that can make a substantial impact on a family’s standard of living in retirement.
Key Takeaway:
Taking advantage of back-door Roth IRA contributions on an annual basis can result in hundreds of thousands of dollars in lifetime tax savings.
Pro-Rata Rule: Important Pitfall
One of the keys to the back-door Roth IRA contribution is converting the non-deductible traditional IRA contribution to the Roth IRA account without having to pay any tax. In the ideal back-door Roth IRA scenario, no tax is due because the individual has no other IRA accounts with pre-tax balances (i.e. traditional IRA, SEP IRA, or SIMPLE IRAs).
If the individual has other traditional IRA, SEP IRA, or SIMPLE IRA accounts, all of these accounts are treated as a single balance when calculating the taxable amount of each conversion. For example, if an individual has $94,000 in a SEP IRA and also makes a $6,000 non-deductible traditional IRA contribution, they will have a total balance of $100,000 in traditional and SEP IRAs. The total basis associated with the $100,000 balance will be $6,000 resulting from the non-deductible IRA contribution.
Assuming the individual converts the $6,000 from the non-deductible contribution in their traditional IRA to their Roth IRA, it would be easy to assume that the entire $6,000 conversion is non-taxable since that can be directly traced to the non-deductible contribution.
However, that is not the case. The IRS applies what is called the pro-rata rule. The pro-rata rule treats all of an individual’s traditional IRA, SEP IRA, and SIMPLE IRA balances as a single account.
Accordingly, in the example above, the individual had $6,000 of basis across their total traditional, SEP, and SIMPLE IRA balances of $100,000. Therefore, 6% of their balance represented basis. Accordingly, only 6% of their $6,000 conversion is non-taxable as demonstrated in the following graphic.
Because of the pro-rata rule, back-door Roth IRA contributions are most beneficial for individuals who do not have other pre-tax traditional IRA, SEP IRA, and SIMPLE IRA balances. For those who do have other traditional IRA, SEP IRA, and SIMPLE IRA balances, there are ways to eliminate them to avoid the pro-rata rule.
Ways to Avoid the Pro-Rata Rule:
First, the pro-rata rule for a Roth IRA conversion only applies to taxpayers on an individual basis. The pro-rata rule does not include the balances of a spouse’s accounts even if a joint tax return is filed. As a result, it is possible for one spouse to be subject to the pro-rata rule while the other is not.
Second, the pro-rata rule only applies to traditional IRA, SEP IRA, and SIMPLE IRA balances. The pro-rata rule also does not factor in balances that are in employer retirement plans such as a 401(k) or 403(b) plans. Often employer plans allow participants to roll outside IRA balances into the employer plan account.
For participants who like the investment options and features of their employer plan account, rolling their IRA balance into their employer plan account will remove those funds from the pro-rata calculation.
For individuals who don’t have an employer plan account or otherwise don’t want to roll their IRA balance into their employer plan account, there is the option to convert the balance in the traditional IRA, SEP IRA, and SIMPLE IRA to a Roth IRA account.
While a Roth conversion is a taxable event, it can open the door for back-door Roth IRA contributions in the future by clearing out the balances in the pre-tax IRA accounts. This is often an attractive strategy if the individual is currently in a low tax bracket or if their pre-tax IRA balances are small.
Key Takeaway:
The pro-rata rule can reduce the effectiveness of the back door Roth IRA strategy for individuals who have other pre-tax IRA accounts. In those cases, additional planning is necessary to work around the pro-rata rule.
Filing Tax Form 8606 Requirement:
Taxpayers who complete a back-door Roth IRA contribution need to ensure they report the back-door Roth IRA contribution correctly on their tax return. This requires that the taxpayer includes Form 8606 with their tax return.
Form 8606 is used to track a taxpayer’s basis in their traditional IRA contributions. Since a back-door Roth IRA contribution includes a non-deductible traditional IRA contribution, Form 8606 is required to demonstrate to the IRS that the conversion of the traditional IRA balance to the Roth IRA is a non-taxable conversion.
At the end of the year, the taxpayer will receive a 1099-R from their custodian reporting the conversion from their traditional IRA to their Roth IRA. Since the custodian doesn’t know whether the taxpayer took a deduction for their traditional IRA contribution, the 1099-R typically shows the total distribution as taxable.
Without filing Form 8606 to report the basis in their non-deductible traditional IRA contribution, the taxpayer would be taxed on the conversion. Filing Form 8606 demonstrates to the IRS that the conversion is not taxable.
Key Takeaway:
Taxpayers implementing a back-door Roth IRA strategy need to ensure they file Form 8606 with their tax returns.
Will The IRS Challenge Back-Door Roth IRA Contributions?
Back-door Roth IRA contributions appear to be an unintended loophole in the Internal Revenue Code. For years, back-door Roth IRA contributions were a grey area, and many CPAs and financial advisors were uncertain whether the IRS would challenge taxpayers who followed a back-door Roth IRA strategy.
However, recently this lack of clarity has been reduced. In a conference report to the Tax Cuts and Jobs Act, Congress stated,
“Although an individual with AGI 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.”
Further on July 10th, 2018 in a Tax Talk Today webcast, Donald Kieffer Jr., tax law specialist (employee plans rulings and agreements), IRS Tax-Exempt and Government Entities Division, stated the following regarding back-door Roth IRA contributions:
“I think the IRS’s only caution would be whenever we see words like ‘back door’ or ‘workaround’ or other step transactions that are putatively enabling a way to get around limits — especially statutory contribution limits — you generally find the IRS is not happy and prepared to challenge those,” Kieffer said. “But in this one that we’re talking about, it’s allowed under the law” (Tax Notes, 2018).
Therefore, both Congress and the IRS have acknowledged that back-door Roth IRA contributions are fully allowed under current law.
Conclusion
Saving for retirement and reducing taxes is a primary focus of many individuals and saving through tax advantaged retirement accounts can accelerate an individual’s ability to reach their long-term financial goals. While the benefits of traditional and Roth IRAs are substantial, they are also restricted for many high-income taxpayers.
In order to benefit from tax advantaged retirement accounts, families with significant incomes often must use creative strategies to remain compliant with the rules and regulations that are in place. The back-door Roth IRA strategy is the most effective way for high-income taxpayers to achieve the benefits of tax-free growth in a Roth IRA account.
These tax benefits over the course of a lifetime have the potential to add up to substantial tax savings totaling hundreds of thousands of dollars. If you are interested in connecting with a family CFO to learn whether a back-door Roth IRA strategy is right for you, we would love to connect to see if what we do is right for you.
