If I had to wager, backdoor Roth IRA contributions are in the top 3 of #personalfinance Slack channel topics.
[Note: The recent House Ways and Means Committee proposal for tax law changes might affect your ability to make backdoor Roth IRA contributions starting next year. We haven’t thoroughly digested the proposal yet, but it could be that it renders this entire concept—and blog post—moot! How inconsiderate…]
Which is kinda funny considering that the $6k involved is a relatively small amount of money for many people working in tech. It’s definitely in the “icing on the cake, not the cake itself” category.
You’ve probably heard of backdoor Roth IRA contributions. You might even feel like you’re missing out because your Inside Voice is always uncomfortably whispering, “Yes, but uh…what are they? Should I be doing it? And if I should be, how do I actually do it?”
Excellent questions, all. Shall we?
What Is a Backdoor Roth IRA Contribution?
Let’s start with understanding what Individual Retirement Accounts (IRAs) are and how they differ by tax treatment. There are two kinds:
- You can always contribute to a traditional IRA (assuming you have earned some income). This year’s contribution limit is $6k, if you’re under 50 years old.
- Whether or not you can take a tax deduction in this current year depends on your income level and whether you have an employer retirement plan. Most of you working in tech who read this blog? You probably can’t take a deduction.
- When you withdraw that money in retirement, you pay income taxes on the money you take out.
- You can contribute to a Roth IRA only if your income is lower than a certain threshold: $140k for a single person, $208k for a couple in 2021.
- You cannot take a tax deduction in this current tax year.
- When you withdraw that money in retirement, you don’t pay income taxes on any of the money coming out.
(There are some nuances, but this is good enough for our purposes.)
“My,” you say, “letting that Roth money grow for decades and then not having to pay taxes on any of that money when I take it out sounds mighty nice. But I make too much money to contribute! Durn!”
Enter the backdoor Roth IRA contribution.
It enables you to effectively contribute to a Roth IRA even if you’re over the income threshold. To summarize how to do it, you:
- Contribute to your traditional IRA.
- Don’t take a tax deduction on it.
- Convert that money to your Roth account.
Boom. Cool kid.
Why Would I Make a Backdoor Roth IRA Contribution?
- You want to save more for retirement. (Technically, you want to save more for years 59 ½—when you can start withdrawing from IRAs without penalty—and older.)
- You make too much to contribute directly to a Roth IRA.
- Your company’s 401(k) doesn’t offer after-tax 401(k) contributions.
- You have the money to do this in addition to your 401(k) savings. 401(k) savings might include not just $19,500 pre-tax but also after-tax up to a total contribution of $58,000 (no really).
Welp, let’s run through those reasons above and see if they apply to you.
Do you want to save more? I mean, generally, the more money you save now, the more Future You will like Now You. And if you work in tech, probably the $6k IRA contribution limit isn’t that big of a bite into your income. (Exceptions always apply, of course.)
So of course as a financial planner, I’m going to reflexively encourage you to save more. But really, whether saving more for retirement/financial independence/the rest of your life is the right choice for you, I can’t know! The decision deserves a little bit of your time and thought.
There are very good reasons to spend money now instead of saving it for later. Reasons like enjoying life now (taking care of Now You) or investing money into your career.
(Side note: If you can spend money this year to make yourself a more valuable worker in some way, you will likely increase your future income way more than an extra $6k of retirement savings this year will increase your future investment growth.)
Are you ineligible to make a direct Roth IRA contribution? If your income is low enough to make you eligible to contribute directly to a Roth IRA, then this backdoor nonsense doesn’t apply! Just contribute directly to the Roth IRA.
Does your 401(k) allow after-tax contributions? If you already have a 401(k) that allows after-tax contributions (which most of the big tech companies do), then that lessens the need for a backdoor Roth IRA contribution.
Why? Because you’re already able to save roughly $30k via a “backdoor” method to a Roth account. It’s just a Roth 401(k) in this case; but 401(k)s and IRAs serve the same purpose, so we’re good.
Do you have the money to save more for retirement than you already can at work? We definitely have clients who are Full Steam Ahead in saving for retirement and so they:
- Max out pre-tax 401(k) at $19,500 and
- Max out after-tax 401(k) at $30,000ish (the exact amount will depend on your company’s matching policy and, more rarely, if they put any other money into your 401(k)) and
- Max out their HSA at $3600 (or $7200 for a family) and
- Max out backdoor Roth IRA at $6,000
But let’s be real…lots of people don’t have That Much Money to save for Future You because Now You needs something, for goodness’ sake.
Here are the mechanics. (After looking here, do you even wonder why so many people screw it up, which they do, lay person and finance professional alike.)
- Check your traditional, rollover, or SEP IRAs. Do these accounts have any pre-tax money in them?
- Contributions to traditional and rollover IRAs are usually pre-tax (i.e., you took a tax deduction when you made the contribution). So if there’s any money in these accounts, it’s probably pre-tax. That said, sometimes people put money into their traditional IRAs and don’t take a tax deduction for it…making the money after-tax.
- If you have pre-tax money in these IRAs, you need to get it out. You must have $0 pre-tax money in your IRAs.
- How? Roll that pre-tax money into your 401(k).
- Your 401(k) has to allow rollovers/roll-ins. Check your Summary Plan Description or other 401(k) paperwork, sometimes even the website, to look at the kind of contributions the plan allows. You should see the word “rollover” or similar. If you work in tech, your plan almost certainly allows this. But check first!
- This process can be a little clunky. Might even involve paper checks and the postal service. It’s silly.
- If you have any after-tax money in your IRAs, be sure to not roll that money into your 401(k). (If you’ve been good about tracking after-tax money in your IRA, you can find that number on IRS form 8606.) The world won’t come down around your ears if you move after-tax money into a pre-tax account, but you will pay double taxes on that money.
- Now that your traditional, rollover, or SEP IRAs contain either $0 or only after-tax dollars (again, that latter one is uncommon), make your annual contribution to your traditional IRA.
- You are not taking a tax deduction for this contribution. Hence, it is after-tax money.
- Ultimately, you are going to convert that $6k to your Roth IRA. And because the $6k is after-tax, and the Roth IRA is an after-tax account, there are no tax impacts of this conversion.
- When you should convert is a matter of some debate. Some experts feel you need some delay—possibly you need to even invest that $6k in the traditional IRA—between contribution to traditional IRA and conversion in order to not invite the gimlet eye of the IRS. The safest way to do this is to invest the $6k in your traditional IRA and maybe wait an entire year before converting that money to your Roth IRA. Many people take a far more aggressive approach to that, all the way up to contributing to traditional IRA and immediately converting to Roth IRA. You have to judge for yourself, alas, what you feel comfortable with.
- If you have no idea how to convert from your traditional IRA to your Roth IRA, then call the 1-800 number for the custodian where your IRAs live and ask them how to do it.
- Your traditional IRAs are now at $0. You need to keep the balance at $0 through the end of the year in which you do the conversion. The “why” is somewhat elaborate, so just know that if the balance is > $0 with pre-tax dollars, you’ll end up paying some tax on the conversion.
Voila! You now have $6k in your Roth IRA even though your income exceeds the income threshold for IRA eligibility. You have performed a backdoor Roth IRA conversion. Congratulations!
The key here is being able to empty your traditional, SEP, or rollover IRAs of all pre-tax dollars.
Now, you might be observing, as I often have: “Hey now. I make a lot of money and so cannot make a Roth IRA contribution directly…but I’m allowed to contribute $30k in after-tax money to my 401(k)? And that money is immediately converted to the Roth account, so effectively I’m making a $30k Roth contribution, which is way bigger than the Roth contribution people with way lower incomes are permitted to make to an IRA? That seems…not right.”
Yep. you got it. It is not logically consistent. It is not fair, in my opinion. But it is legal. And absolutely what you should do if you can afford the extra savings, to maximize your own financial resilience and opportunities.
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Disclaimer: This article is provided for educational, general information, and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Meg Bartelt, and all rights are reserved. Read the full Disclaimer.