The Backdoor Roth
A backdoor Roth contributes to a traditional account without claiming a deduction and then converts that balance to a Roth. Where a pro-rata rule applies, existing pre-tax balances are counted in the conversion, which is what makes the strategy expensive for many people.
Direct contributions to a Roth account phase out above an income level. This is the route people use instead, and whether it is straightforward or expensive depends on one rule that has nothing to do with income.
How it works
Step one: contribute to a traditional individual account without claiming a deduction. There is generally no income limit on making a non-deductible contribution, which is what makes the route available.
Step two: convert that balance to a Roth account. Because the contribution was already taxed, converting it produces little or no additional tax — only any growth between the two steps is taxable.
That is the whole strategy when there is nothing else in the way. The complication is what happens when there is.
The pro-rata rule
Where it applies, a conversion is treated as coming proportionally from all your individual retirement balances, not from the specific dollars you just contributed.
So the after-tax contribution cannot be isolated. If most of your individual retirement money is pre-tax, most of the conversion is treated as pre-tax and taxed accordingly.
Which turns a routine step into a tax bill in the year it is done, on money that was not intended to be converted at all.
The ratio is measured at the end of the year, not on the day of the conversion. Form 8606 uses the combined value of all traditional, SEP and SIMPLE individual accounts on December 31 of the conversion year. A November rollover into one counts against a February conversion; a balance moved into a workplace plan before year-end does not.
A worked example
Take $7,000 contributed after tax, alongside an existing 63,000 pre-tax balance.
The total across the individual accounts is 70,000, of which 7,000 — 10% — is after-tax.
Convert 7,000 and only 10% of it is treated as a return of after-tax money. The other 90%, 6,300, is taxable income this year.
At a 32% rate that is 2,016 of tax on a step most descriptions present as costless. With no pre-tax balance at all, the same conversion produces almost nothing.
Clearing the way
Workplace plan balances are generally not counted in the ratio. So rolling an existing pre-tax individual balance into a current employer’s plan, where the plan accepts it, can remove the problem.
Which reverses the usual advice about consolidation. The rollover page recommends moving old plans into an individual account for the wider menu and lower fees — and that is exactly the move that closes this door.
Anyone who might use this strategy should decide the order deliberately, because the two pieces of sensible advice point in opposite directions.
The order that works is usually: clear the individual accounts first, then use the route. Move any pre-tax individual balance into a workplace plan while you still have access to one, and only then start the annual contribution-and-convert cycle.
Doing it the other way round is the common sequence and the expensive one, because a rollover made for good reasons in one year makes the strategy costly in every year afterwards.
Records
Non-deductible contributions create basis that must be reported and carried forward. Fail to file it and there is no record that the money was already taxed, which means paying tax on it twice.
That reporting is annual and cumulative, and it is the most commonly missed part of the whole procedure. Rules are statutory, national and revised — check the current requirements. This is educational, not tax advice.
Costs
Leaving the contribution invested between the steps creates taxable growth. Most people convert promptly and hold cash in between, which keeps the taxable amount near zero — and means a few days out of the market.
Of all ten-trading-day stretches in the S&P 500 since 1950, 59% finished higher. A short gap is a small exposure and it is not nothing, which is the trade against a slightly larger taxable amount.
The original data
Among the 24,971 unique videos in this site’s search study, the nearest account subjects are Roth accounts, in 24 videos at a median of 95,293 views, and workplace plans, in 22 at 81,626.
It is procedural and jurisdiction-specific, which is why the order of operations deserves more attention than the strategy itself.
The question: Income has risen past the limit. Use the backdoor?
The answer is that it depends entirely on what else sits in your individual retirement accounts. With nothing pre-tax there, it is a two-step administrative task. With a large pre-tax balance it is a tax bill dressed as an administrative task — and the order of operations, not the strategy, is what decides which one you are doing.
When it fails
The failure is doing it without checking the pro-rata position first. The contribution goes in, the conversion is processed, and a tax bill appears months later on a step everybody described as free. Nothing was done incorrectly; the pre-tax balance sitting in an account opened years earlier was counted, and by the time the arithmetic is visible the conversion has already happened and cannot be undone.
The second failure is not reporting the basis. Unreported after-tax money gets taxed twice.
A third is consolidating old plans into an individual account first. That creates the balance that causes the problem.
A fourth is leaving the contribution invested for months. Growth between the steps is taxable.
A fifth is assuming the rules are stable. This route exists because of how the rules currently interact.
And a sixth is doing it without needing to. Below the income limits, a direct contribution is simpler and has none of this.
Related
Roth IRA is the destination and why it is worth reaching. Rollovers is the move that can close this route. And 401k is the plan that can hold the balance out of the way.
The pro-rata rule is the part that decides whether this is worth doing, and it is the part almost every summary leaves out. With no pre-tax individual balances it is clean. With a large one it can turn a routine step into a substantial tax bill in the year you do it, which is a very unwelcome surprise.
— Michael Whitman
This page is educational, not financial advice. Test every idea on your own charts before risking money.