The so-called backdoor Roth is one way one can avoid a big tax bill when you earn more than the income limit for a Roth.
In that case, if you’re also covered by an employer retirement plan like a 401(k), you likely wouldn’t be able to fund a deductible IRA, because of IRS rules. But you could contribute to a nondeductible IRA (regardless of how high your income is), and then convert to a Roth.
When you contribute to a nondeductible IRA, you’re effectively depositing after-tax dollars, so you’d only owe tax on the earnings when you withdraw (or convert). If you convert to the Roth soon after, any earnings, and therefore taxes, are likely to be minimal.
The Pro Rata Rule
This method can be most beneficial tax-wise if you don’t have other deducted IRA funds, including those previously rolled out of a 401(k), SEP IRAs, or Simple IRAs. If you do, then the portion that you convert to the Roth has to be prorated over the total amount you have in all your traditional IRAs, SEP IRAs, and Simple IRAs. This is an important point that often surprises IRA converters at tax time. Read more about the IRS pro-rata Rule.
If you have an employer plan that allows you to “roll in” funds from IRAs, you can avoid the taxes on conversion by first moving any previously deducted IRA balances into your employer plan. You’d do this first, before any conversions.
So to review, execute a backdoor Roth conversion with these three steps:
- Minimize pre-tax IRA account balances by rolling them into your employer plan, if possible.
- Make a current year traditional IRA contribution, and don’t deduct it on your taxes (also report on Form 8606).
- Form 8606 is where after-tax Traditional contributions are tracked and helps determine how much of a conversion or distribution is taxable.
- Execute a Roth conversion of the contributed amount
At Betterment, we do not track whether or not you take a deduction on your Traditional IRA contributions. You keep track of this yourself when you file IRS Form 8606 with your tax return.
You aren’t able to open multiple Traditional IRAs to keep pre-tax and post-tax contributions separate, because even if you did, the IRS would view them all as one account anyway, due to the pro-rata rule mentioned above. The same rule applies across Simple IRAs, SEP IRAs, and even Traditional IRAs held at other providers.
The only way to truly isolate after-tax contributions to a Traditional IRA would be to roll any pre-tax money (which also includes earnings on after-tax contributions) into an employer-sponsored plan, such as a 401(k), 403(b), 457 governmental plan, of Thrift Savings Plan (TSP).
Carpé Career Change
Another way to help minimize taxes is to plan ahead, if you can, when you know that a career or life change is coming that will push you into a lower tax bracket. Then, when you convert from a traditional IRA to a Roth, the tax you’d owe would be based on that lower bracket.
Consider these major life events:
- Going to graduate school
- Making a career change that lands you in a lower-paying (but perhaps more rewarding) line of work
- A planned or unplanned period of unemployment.
- Starting your own business
In each case, you can and should continue to save in tax-deferred accounts prior to making the conversion. Then, when the life transition is underway, you can strategize about the amounts you plan to convert and when, depending on your new tax bracket.
Bear in mind that the amount you convert is considered income (except the after-tax portion), so you want to make sure that amount doesn’t bump you up into a higher tax bracket. Again, this example is only an illustration; individual specifics could change the numbers.
The greater point is that converting to a Roth may be highly desirable from a tax perspective down the road—so understand the Roth IRA rules and don’t let the tax bill today stand in your way.