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Back Door Roths

Back Door Roths

| June 04, 2018
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I am often surprised at the number of high income earners I meet who are not availing themselves of the "Back Door Roth". Under certain circumstances, it can be a highly effective strategy for those who are "income phased out" of making a normal contribution to a Roth.

Generally speaking, everyone can contribute to a non-deductible IRA regardless of whether they are contributing to an employer retirement plan or not, make a lot of income, etc. It allows you to contribute the annual maximum ($5,500 before 50 and $6,500 after 50) in dollars already taxed to an IRA and accumulate/shelter the earnings from taxation until withdrawn. But what's even more attractive, is to contribute dollars to a non-deductible IRA and soon thereafter, convert them to a Roth IRA. Why? Because the earnings accrued are not taxed upon distribution. They accumulate tax free and are withdrawn tax-free.

We've all heard some iteration of the saying "the only two things that are guaranteed in life are death and taxes". And thus, diversifying assets and income into a group of differently taxed vehicles (see below) can help people get more from their savings in retirement by managing taxes more effectively:

  • "After tax money". Think "brokerage" account. You usually pay annual taxes on interest/dividends and realized capital gains.
  • "Tax deferred money". Usually your 401k contributions are contributed in "pre-tax" dollars and/or your traditional IRA and both the earnings and contributions are taxed upon withdrawal.
  • "Tax free". Roth IRA, contributions/earnings made to a Roth 401k or "after tax" section within your 401k are not taxed on withdrawal.

Things to consider and some caveats when evaluating appropriateness of the "Back Door Roth" strategy for your situation:

  • Existing IRAs. If you have only retirement dollars held in Roths or in your company's retirement plan then is it much easier to implement this strategy. As per Michael Kitces, CFP®"... the IRA aggregation rule often limits the effectiveness of the strategy, because the presence of other pre-tax IRAs and the application of the 'pro-rata' rule limits the ability to convert just a new non-deductible IRA." However, if you still feel the back door Roth strategy is one you want to employ, then you could investigate the following strategies:
    • Roll existing IRAs into your 401k. You could consider rolling your existing pre-tax IRA assets into your company's retirement plan thus eliminating your current IRA holdings. Consider your 401k plan parameters, investment choices available within the plan and the fees/costs.
    • Roth conversion. The IRS, regardless of annual income, allows people to convert all or a portion of existing traditional IRAs into Roths and pay income tax on the dollars converted in the current tax year. Consider implications to your current vs. future tax situation, legacy wishes (Roths have no required minimum distributions at 70 ½ for original owner), and consult with your trusted legal, tax and/or financial professionals.
  • Future tax bracket. Do you think you will pay as much or possibly, more, taxes in retirement? If so, accumulating Roth dollars might have merit for you as it will allow you to strategize which "bucket" you will pull from in order to more effectively manage your taxes in future years.
  • After tax 401k dollars. Let's say you are in a position to max out your annual contribution to your 401k account. And, you want to save more for retirement and like the idea of accumulating future tax free dollars. One strategy is to contribute dollars to the "after tax" component of your 401k account if allowed in your plan. NOTE: this is over and above the annual maximum allowed in either the pre-tax or Roth sections of your 401k account. You pay taxes, this year, on contributions made to the "after tax" component and upon leaving the company, those accumulated dollars (including earnings) can be rolled directly into a Roth IRA or combined with your existing Roth account.

Remember, as the saying goes, "the only thing in life that is assured is death and taxes"! The "Back Door Roth" might be helpful in addressing at least the tax part of that statement. Good luck.

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