Backdoor Roth IRA: Appropriate Or Not?

2014-07-14_0813Last week I received a phone call from a very nice young woman, Stephanie. She is a faithful Cutter Family Finance reader who wants to stay financially fit.
Stephanie wants to contribute to a Roth IRA. She is concerned about taxes rising in the future and she does not want to bear that burden. Smart gal. The problem is that she earns too much money to contribute to a Roth IRA. Stephanie asked her broker about any solutions available to her that will allow her to contribute to a Roth under her current situation. She told me that her broker advised her to do a “backdoor Roth IRA.”
Hmmmm . . . not so fast.
A backdoor Roth IRA can be a solution for investors who make too much income to qualify for normal Roth IRA contributions, and want to increase their retirement savings in tax-advantaged accounts. This is because with a Roth IRA your hard-earned money grows tax-free, and you are allowed to withdraw those funds tax-free in retirement (don’t forget, you do pay tax up-front in that you contribute with after-tax dollars because you don’t get a tax deduction when you make the contribution). Furthermore, unlike traditional IRAs, there are no required minimum distributions for Roth IRAs and they can be passed on to one’s heirs. This allows the funds to grow tax-free over many years, and offers tax-free compounding and withdrawals. However, there are limits and complications involved with “backdoor Roth IRAs.”
Stephanie’s broker advised her to begin a two-step process for her to create a backdoor Roth IRA. He suggested that she first, contribute to a (nondeductible) Traditional IRA because unlike a Roth IRA, a traditional IRA has no income ceiling for contributors. Next, after the funds clear, he suggested she convert the traditional IRA to a Roth IRA in order to never pay taxes again on her investments. He told her that since no time elapses between the contribution to the Traditional IRA and the conversion to the Roth IRA, there are no earnings on those funds and it is a non-taxable event, unlike if she were to convert pre-tax IRA funds, (tax deductible IRA money and earnings which have not been taxed yet) into a Roth IRA, in which case all gains are taxed on the conversion at current rates. Sounds great!
Not so fast.
Bring in the “pro rata tax rule.” The pro rata rule is the factor that can complicate a backdoor Roth IRA, even if it otherwise sounds like it might be for you. This is how it works: if there are any pre-tax IRA funds in any other IRA (for instance, an old 401k that you have rolled over), the conversion of any contributions becomes a taxable event which will result in taxes being paid on the conversion. Generally you can’t convert just that nondeductible IRA contribution tax-free when you have other IRA funds.
Stephanie was very surprised to hear this because she was told that since any contribution to a backdoor Roth comes from an immediate conversion from a nondeductible IRA, it is a nontaxable event. Although generally speaking that is true, there is a big exception: if you own any pre-tax IRA, including SEP and SIMPLE IRAs. If Stephanie owns IRAs with both nondeductible and pre-tax funds, then each dollar withdrawn (or converted) from any of her IRAs will contain a percentage of tax-free and taxable funds based on the percentage of after-tax funds to the entire balance in all her IRAs. She cannot just withdraw (or convert) the nondeductible IRA contribution and pay no tax. Stephanie also has about $95,000 of pre-tax IRA money being held in various accounts with her broker. And even though these funds are held in separate accounts, the IRS looks at them as one IRA.
So, let’s assume Stephanie contributes $5,000 into a non-deductible traditional IRA, and soon after converts that $5,000 into a Roth IRA, utilizing the backdoor Roth strategy. If Stephanie had no other IRAs, the conversion to the Roth IRA would be tax-free. However, since she has other IRA assets, well, we have a problem. 
The pro rata rule requires Stephanie to aggregate all of her IRA money that has not been taxed yet and views the $5,000 as a percent of the total IRA pool of (non-taxed) funds. The $5,000 converted to a Roth is considered 5 percent of her total IRA assets ($5,000/$100,000). Her percentage of pre-tax funds in her IRA is therefore 95 percent, and upon conversion of the $5,000, she will be taxed up-front on $4,750 of the $5,000. As you can see, the backdoor Roth is not as advantageous a strategy for Stephanie as it may be for others and I advised her against it.
Given the benefits outlined above, backdoor Roth IRAs are certainly something to consider when you are charting your course for retirement savings. Specifically, if you have already maxed out other retirement savings options, you are willing to leave the money in the Roth for at least five years, and you expect to be in a higher tax bracket in retirement than you are currently, it is something to consider.
Folks, backdoor Roths are not for everyone, so if you do consider it, make sure you carefully contemplate all the ramifications. If you already have any traditional IRAs or can contribute to any other retirement savings vehicles, make sure to do the math to see if a backdoor Roth IRA is for you.
I finished the call with Stephanie by advising her to make sure she seeks her retirement solutions from a retirement specialist. It could save her a small fortune. I advise you to do the same. Have a great week!
And remember . . . be vigilant and stay alert, because you deserve more.