The “Back Door” Roth Strategy
Until 2010, high income investors could not contribute to Roth IRAs or convert Traditional IRAs to Roth IRAs. The Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA) included a provision that, beginning in 2010, removed the income limitation for converting Traditional IRA balances to Roth IRAs.
Although the income limitation continues for contributions to a Roth IRA (For 2014, the income limits are $191,000 modified AGI for married filing jointly, $129,000 modified AGI for singles), the removal of the income limitation for Roth conversions created an opportunity for some high income investors to effectively make Roth IRA contributions through a “Back Door” strategy, BD for short.
First, a brief comparison of Roth IRAs and Traditional IRAs. Both types of IRAs offer tax deferred growth of assets while the assets remain in the IRA. The difference is that Traditional IRA distributions are taxed as ordinary income while Roth IRA distributions are tax-free.
The benefits of a Roth IRA are potentially enormous as all earnings and distributions are tax-free.1
Taxed as ordinary income
*Pre-tax if made with deductible contributions or rollovers from an employer sponsored plan such as a 401k.
A standard Roth conversion of a pre-tax Traditional IRA has the unfortunate feature that the converted assets are treated as a taxable distribution, thereby making it an expensive proposition even if it ultimately makes the investor better off. 2
The BD Strategy
Unlike a standard Roth IRA conversion, the BD strategy provides an unambiguous benefit to the investor. The specific situation that creates the BD strategy opportunity is when a high income investor has no pre-tax Traditional IRA money.
The following illustrates the process and why not having pre-tax Traditional IRA assets is the key.
The BD strategy works through a two-step process.
Step 1: Make a standard non-deductible Traditional IRA contribution (2014 limit is $5,500 for those under 50 years old, $6,500 for those 50 years and older).
Step 2: Convert the Traditional IRA balance to the Roth IRA.
Situation 1 – Investor has Pre-Tax IRA Assets: Since the converted assets are a taxable distribution, any assets converted that have not previously been taxed, will be. Note that converted assets can’t be cherry-picked to avoid taxation. If the investor has pre-tax Traditional IRA assets, the basis of the conversion will be calculated on a pro-rata basis. For example, suppose an investor has $100,000 in pretax assets in a Traditional IRA. She then makes a $5,500 non-deductible (after-tax) Traditional IRA contribution. If she then converts $5,500 to a Roth IRA, tax will be owed on 95% ($100,000/$105,500), or $5,225 (.95 x $5,500) of the converted assets.
Situation 2 – Investor has no Pre-Tax IRA Assets: The converted assets are still a taxable distribution. However, in this case the basis of the converted assets is equal to the total Traditional IRA balance. So for example, if the investor makes a $5,500 non-deductible (after-tax) Traditional IRA contribution and then immediately converts the entire $5,500 balance to a Roth IRA, tax will be owed on 0% ($0/$5,500) of the converted assets.
The BD strategy can be executed each year as long as the investor is eligible to make Traditional IRA contributions.
One interesting issue the BD strategy raises is that the conventional idea that 401k balances should always be rolled into an IRA may not be the best option. In fact, purposely not rolling over 401ks may be the best move when switching jobs if the BD strategy can be implemented.
1 Roth IRAs have the additional benefit of not requiring minimum distributions after the account holder turns 70 1/2. This can create interesting estate planning opportunities.
2 A thorough analysis of the costs/benefits of a standard Roth conversion requires a separate discussion.
is the founder and principal of Westchester, New York-based, Fifth Set Investment Advisors LLC, a Fee-Only, SEC registered investment advisory firm. Following a career in equity research, an examination of competing investment management approaches led Ian to create Fifth Set to offer clients customized wealth management strategies built on a foundation of evidence-based financial theory.