Pros and Cons of Creating a Backdoor Roth IRA

Taxpayers whose incomes exceed certain annual thresholds are not allowed to make direct contributions to Roth IRAs under current tax law. However, Congress was kind enough to remove the Adjusted Gross Income (AGI) threshold limit on Roth conversions, which allowed many taxpayers to move their traditional plan balances into Roths and escape taxation on them.

This revision in the rules also opened up a loophole for taxpayers with incomes above the AGI limits for contributions. Since there is no income limit for conversions, those in this category can now move money into a Roth IRA each year by contributing to a traditional IRA that is nondeductible and then converting the balance into a Roth account.

This backdoor strategy is perfectly legal and allows wealthy taxpayers to effectively accumulate a pool of tax-free cash for their retirement, but there are also some potential drawbacks that need to be considered. (For more, see: Is a Backdoor Roth IRA Suitable for You?)

The most obvious benefit to using the backdoor strategy is, as mentioned previously, that high-income earners can use it to create a tax-free pool of cash they can use in retirement. For those in the top two tax brackets this can be a real boon, especially if they are young enough to allow their contributions to grow into a sizeable sum.

A tax-free withdrawal of $40,000 for example leads to significant savings for someone in the 39.6% tax bracket compared to someone in one of the bottom two brackets. The strategy is also relatively easy to accomplish. All that is required is to open a Roth and traditional IRA (if the taxpayer doesn’t have either of those already) and then make one deposit followed by a single transfer (and double this process for married taxpayers who file jointly).

You can use this strategy if your income is right near the AGI limit for the year for Roth contributions (the phaseout starts at $118,000 for single filers and $186,000 for marrieds filing jointly in 2017). This way you won’t have to re-characterize your direct Roth contributions if your income happens to rise above the limit. (For more, see: Can I Buy ETFs for My Roth IRA?)

Although the procedure for the backdoor strategy is fairly straightforward, it is possible to commit some errors which may become rather inconvenient to correct.

For example, if you make your contribution to the nondeductible traditional IRA and then leave it there until it accumulates sufficient investment income to exceed the full contribution amount before you convert it, you will have to reverse the excess amount of the conversion before the end of the year or face a stiff fine from the Internal Revenue Service.

A more common issue that many taxpayers who use this strategy face is contributing the full amount and then converting it when they have other traditional IRA, Simplified Employee Pension or SIMPLE IRA balances elsewhere. When this happens, the taxpayer is required to compute a ratio of the monies in these accounts that has been taxed already versus the aggregate balances that have not been taxed (in other words, all tax-deferred account balances for which you deducted your contributions versus those for which you didn’t).

The amount of the contribution and conversion is then multiplied by this percentage, and the product is then counted as taxable income. This also means that you should not roll over a traditional employer-sponsored retirement plan into a traditional IRA in the same year that you use this strategy, because the entire balance will increase the amount of contribution on which you will owe tax. (For more, see: How Can I Fund a Roth IRA if My Income is Too High?)

One other possible drawback to using the backdoor contribution is from legislative action. Congress never really intended to create this loophole when they repealed the income limit for conversions in 2010. The Obama Administration made one attempt to close this loophole with legislation that was proposed in 2016.

While most financial legislation only applies to transactions going forward, there is at least a theoretical possibility that the elimination of this loophole may be applied retroactively, which would mean any backdoor contributions that you have made might have to be reversed at some point. The odds of this happening are admittedly rather low, but if it does, you may need to file several amended tax returns with a balance due on each one.

Backdoor Roth IRA contributions can be a godsend for wealthy taxpayers who are unable to move money into a tax-free account by any other means. But those who have outstanding pretax IRA balances of any kind must know how to calculate the correct taxable percentage for their contributions or risk an audit that will result in additional taxes owed plus interest and penalties. (For more, see: I Maxed Out My IRA! Now What?)