A Back Door Roth IRA is a great way to get assets into a Roth account if you are over the income limit to directly contribute to a Roth IRA. The income thresholds for 2023 are $153,000 if single and $228,000 if married filing jointly. So, how do you put money in a Roth if you are over these income thresholds? You use the back door of course! To do this, you need to:
- Open and contribute money into a Traditional IRA.
- Allow time for the funds settle in the account (generally a few days)
- Complete a Roth conversion with the funds you deposited.
- File Form 8606 during tax season.
It may seem weird that this “loophole” exists, but I can safely say that it does, and the IRS has approved it. The law says you cannot directly contribute to a Roth account if you are above the income thresholds, but, by taking the steps I just outlined, it is perfectly legal. After the appropriate steps are taken, viola! You have now converted your IRA contribution into a Roth IRA.
There is one hiccup though, the pro rata rule. The pro rata rule catches a lot of people by surprise as they think there are no tax implications. So, let’s try and understand it: Traditional IRAs permit taxpayers to make either pre-tax or post-tax contributions. This potential mix of both pre-tax and post-tax contributions can make Roth conversions complicated since taxes will be owed when converting pre-tax dollars into Roth accounts, and many do not anticipate this (likely attributable to the “backdoor” jargon).
The pro rata rule states that when you convert a Traditional IRA to a Roth IRA, you are taxed based on the proportion of pre-tax dollars to post-tax dollars in all Traditional IRAs. In short, you cannot dictate that your Roth conversion will only use post-tax funds. How does this work in practice?
Let’s say you contributed $6,000 last year to an IRA and got a tax deduction for it (pre-tax). This year, you are over the income threshold, so you decide to do another $6,000 contribution but do not take a tax deduction. Your IRA is now $12,000 with $6,000 being pre-tax dollars (from prior year, 50%) and $6,000 being post-tax dollars (this year and the other 50%). When you go to convert the $6,000 to your Roth, 50% of that conversion, or $3,000, will be income subject to taxation thanks to the pro rata rule and often in income brackets many would prefer to avoid (i.e., high earning years and pre-retirement). This is a very basic and straightforward example, but I hope it helps understand the nuance.
Remember that the proportion is based on pre-tax dollars for ALL Traditional IRA accounts. This includes any prior employer 401(k)s which were rolled into an IRA. It makes sense (if possible) to keep pre-tax 401(k) dollars in a 401(k) to avoid this complication.
It is once again an illustration of how crucial it is to consider tax planning in conjunction with financial planning.