I kind of love the question; “why do I have to do the Roth IRA through the ‘back door?’” because it is a tax-technical answer and I get to nerd out on my explanation.
But, it doesn’t take away from the fact that this is just some silliness going on with retirement contribution rules. At the end of the day, if you can still make the Roth contribution, why do people have to jump through hoops to do it?
I’m not totally sure, but I guess the complication adds job security for me!
I feel the need to comment about the ‘death of the Roth’, which I’ve heard here and there. What I mean by this is that many high income earners have expressed concern with putting money into Roth accounts for fear of the government changing the Roth rules in the future.
There was also an initial draft of a retirement bill that was going to do away with the back door Roth IRA and the mega back door Roth. But, not only did that part of the bill get killed, but more opportunities for Roth contributions were put into the new bill that was recently passed (the Secure 2.0).
At the end of the day, Roth features make the government’s short-term budget numbers look great. If there is no Roth, then people would utilize traditional-type retirement accounts, which would defer income and subsequently defer taxes.
But with Roth, the taxpayer has to recognize income and pay taxes today - which makes the government’s short-term budget look great! They are happy to tax you today; use Roth accounts and convert to Roth all you want so they can collect that money now. This will make their policies look budget-friendly and more likely to pass and push other new features through.
Do I think the Roth is going away any time soon? No, but I may be more trusting than others, and I’ll let you decide for yourself 🙂
Another point to call out up front is what is called the ‘pro-rata rule’ when completing a back door Roth IRA contribution. If you already have money in a Traditional IRA, a SEP IRA or a SIMPLE IRA, the rules are different for you and you should probably talk to a tax or financial professional before completing a back door Roth IRA. The specifics to this is beyond the scope of this blog.
Below are the steps and reasons for having to go through the back door. I will note, due to the timing of this post, you still have until filing your 2022 tax return to contribute for 2022. So I’ll be using the 2022 contribution limit of $6k in my examples - which was increased to $6,500 for 2023.
Well I just spoiled the contribution limit, but in 2022 you can contribute up to $6,000 per person. This is TOTAL between your Roth IRA and Traditional IRA, and is totally separate from any employer sponsored plan contributions (like 401(k), 403(b), etc.).
Again pointing out that this is per person - if you're married, you can each do $6k for a total of $12k. You are required to have earned income to contribute to an IRA - but there is a rule by which you can use spousal income for both of your contributions. In other words, you both do not need income to fully fund your IRAs.
2. Income limits
There are income limitations to a few things, as illustrated by my subcategories:
Roth IRA Contributions: there is a limit to how much income you can have in order to make a standard Roth IRA contribution (through the front door?). That income limit changes each year and you can find it on the IRS website - this blog is about the back door, not all doors.
The income limitation is the entire reason why you have to do a contribution through the "back door".
Traditional IRA Contributions: there are NO INCOME LIMITS when it comes to contributing to a Traditional IRA. Everybody can contribute the maximum amount every year (unless they have no earned income, but if that is the case then this isn’t the blog post for you).
But the ‘gotcha’ here is that there is an income limit to the deductibility of a Traditional IRA contribution. If you have access to a company-sponsored retirement plan, then you are considered an “active participant” to the IRS - which lowers the income threshold that determines if your contribution is deductible. If you can’t contribute to the Roth IRA because your income is too high and you are an active participant, then it is highly likely that you can’t deduct your Traditional IRA contributions.
Roth Conversions: There are NO INCOME LIMITS to being able to convert your pre-tax balances to Roth. That is all you need to know here. You can convert as much as you want, no matter the size of your income.
3. Actual process / putting it together
You can’t contribute directly to your Roth IRA because your income is too high. You can’t deduct your Traditional IRA contribution because you’re an active participant and your income is too high. So instead you:
1. Contribute $6k to a Traditional IRA, recognizing you won’t get a tax deduction. This is “after-tax” money in your IRA, or in other words, you have basis. You were already taxed on that money and will not be taxed on it again.
You could keep that money in the Traditional IRA and invest it; any investment earnings within the account would be taxed at ordinary income upon distribution just like other traditional balances, and your original $6k would come out as a return of basis when it gets distributed. Or you follow the next step:
2. Don’t invest the money, but first convert (fancy term for transfer) your $6k from your Traditional IRA to your Roth IRA. You already paid tax on the $6k before you contributed it into your Traditional IRA; so you don’t have to pay any tax on the conversion and now the money is in the Roth IRA.
Now that it is in the Roth, all investment earnings will be tax-free, assuming you follow all the Roth rules.
4. Timeline / deadlines
There is only one deadline to stay on top of, which is when you need to contribute to the Traditional IRA. You have until the tax filing deadline to do so. Therefore, 2022 needs to be completed prior to 4/18/2023.
You can also do it as early as the first day of the year. So your 2023 contribution could have been, or must be made between 1/1/2023 - 4/15/2024.
Converting your money to the Roth IRA doesn’t have a deadline. I would recommend you do it sooner rather than later so that you can get the money invested and growing, but the conversion can happen at any time.
5. Tax reporting
Finally, the major step that I see missed is the accurate filing of this contribution on your tax return. Once you make the contribution to the Traditional IRA, you’ll file a Form 8606 for the year of contribution (even if the contribution happened after year-end).
This form tells the IRS “I contributed to a Traditional IRA and wasn’t allowed to deduct it, and therefore I have basis in my IRA”. This way, when you get a 1099-R tax form after converting your Traditional IRA to your Roth IRA, you can point to the Form 8606 to say this was after-tax money, which results in a tax-free conversion.
This is certainly an overly-complicated way of making a Roth IRA contribution, especially for a widely recognized way of doing it. I would argue this is no longer a loop hole since the strategy is accepted by the IRS.
Additionally, it doesn’t make a whole lot of sense that having money in a 401(k) makes this a much easier process than if somebody else has that money in a Traditional IRA.
But, nonetheless this is the world in which we live and the rules that I follow.
There is a whole other set of rules when it comes to the mega back door Roth; and yes of course this is a totally separate process and strategy that can be used alongside the back door Roth IRA! It just has to be available through your employer-sponsored retirement account, which I don’t see too often.
If you have any questions on if you can complete a Roth IRA contribution for 2022; hit me up.