It’s the beginning of tax season, and many lawyers are looking for ways to make some last minute changes to save on taxes (thankfully, there are a few contributions you can still make for last year).
One of the best retirement accounts available is the Roth IRA. High-earners can contribute to the Backdoor Roth IRA, which is a simple two-step process for getting $5,500 into a Roth IRA if you are over the income limit. If you contribute $5,500 every year for the next 30 years, you could end up with a beautiful side account worth $479,000+ (in inflation-adjusted dollars). If you’ve never heard of a Backdoor Roth IRA, read this post first. You need to understand this account.
Each year the Backdoor Roth IRA generates some standard questions, so I thought I’d put together a post addressing the most frequently asked questions. If you have more questions, leave them in the comments, and I’ll update this post over time.
Does the IRS Approve of the Backdoor Roth IRA?
I’m not aware of any situation where the IRS has reversed a Backdoor Roth IRA. If you know of one, please let me know. I’ve also never seen a tax court case resolving the matter one way or another. The most visible support from Congress for the Backdoor Roth IRA came in several footnotes to the Tax Cut and Jobs Act. It’s clear that everyone, from Congress to the IRS to the financial institutions are aware of the Backdoor Roth IRA. Just look at the ad from Fidelity below.
If the IRS or a tax court invalidates Backdoor Roth IRA contributions, we’d have quite a mess on our hands. Each year investors make thousands and thousands of Backdoor Roth IRA contributions (more than 20,000 at Vanguard alone, according to Vanguard’s helpful guide on Backdoor Roths).
Can I Do the Conversion Right Away or Should I Wait?
I seriously doubt you’re fooling anyone by waiting a week, a month or six months. Personally, I do the conversion right away. The IRS seems fine with that too. I’m skeptical that we’ll ever get to a place where a tax court allows Backdoor Roth IRAs but disallows those were the conversion happens in a short time frame. Not everyone agrees with me, so you’ll have to make your own decision here.
How Should I Handle the Interest?
The below is a typical question from a reader:
I did a Backdoor Roth IRA for the first time and contributed $5,500 to a money market fund which generated 16 cents in interest while I was waiting to convert the amount. Will I owe taxes now? How do I account for the 16 cents of interest? Can I convert all $5,500.16 to a Roth IRA? HELP!
Uh, this one is pretty easy. You can round cents down to the nearest dollar if it’s less than 50 cents or up to the nearest dollar if it’s above 50 cents. Congratulations, you’ve just netted a tax-free 16 cent conversion. Nobody cares about your 16 cents.
What happens if you wait a couple of months to do the conversion and now your 16 cents is $1.16? Well, you’re going to owe taxes on the extra converted $1. It’ll probably cost you somewhere between 40-50 cents. Again, nobody cares about your extra $1, but now you’ll have to go through the trouble of reporting it. The extra $1 gets reported on Form 8606 on Line 8 (i.e., you’ll have to fill in $5,501) which transfer over to Line 16 and will result in you needing to put $1 in line 18. That’s it.
But what if you didn’t convert the $1.16 this year and now it’s sitting in your Traditional IRA? Leave it sitting there for a year and convert it next year when you do the Backdoor Roth IRA. It’ll still only be an extra $1 of taxes since there’s no way that $1.16 is growing to $2.
I have a Traditional/SEP/SIMPLE IRA – How Do I Avoid the Pro Rata Rule?
The pro rata rule forces you to convert both the non-deductible portion of your Traditional IRA (the contribution that is step 1 of the Backdoor Roth IRA) and any pre-tax money in your Traditional/SEP/SIMPLE IRA accounts, pro-rata. In other words, if you convert $5,500, you’ll be converting part of your non-deductible contributions (good) and part of your pre-tax contributions (bad). You’ll owe income taxes on the portion of pre-tax contributions being converted.
To avoid the pro rata rule, you have three options, all of which involve getting rid of the IRA.
- Reverse Rollover. Many 401(k) plans will allow you to do a reverse rollover, which just means that they’ll accept an incoming transfer of funds. If you’re happy with your 401(k) at work and they allow incoming rollovers, transfer your IRA into your 401(k).
- Open a Solo 401(k). Not a lot of people realize that it’s pretty easy to open up a Solo 401(k) with minimal self-employment income (do a couple of surveys, make a couple of deliveries on PostMates or take a few dogs for a walk on Wag). Get an Employer Identification Number. Voila! You’re self-employed. It’s not about how much money you make. It’s about making a small amount and having an EIN so that you can open up a Solo 401(k). Make sure your Solo 401(k) accepts rollovers (Vanguard doesn’t). Then roll that Traditional/SEP/SIMPLE into the Solo 401(k) by December 31st and now the backdoor is open!
- Convert the IRA. You can always convert the IRA into a Roth IRA and simply pay the taxes. If you’re talking about an IRA with a small balance, this may be the easiest move. You’ll pay income taxes on the amount converted, but you’ll get to deposit the entire amount into a Roth IRA where it will never be taxed again.
Should I Make My Non-Deductible Contributions Monthly?
Many people contribute to retirement accounts throughout the year, using each paycheck to chip away at the total. For the Backdoor Roth IRA, the question is then whether you should make a non-deductible contribution each paycheck to your Traditional IRA until the point that you have $5,500 in the account. This seems like a lot of work to me, and you certainly don’t want to do multiple conversions throughout the year (unless you’re a glutton for logging into accounts and pushing buttons). I’d just save up the $5,500 in a side account. Once you reach the limit, make the entire non-deductible contribution to your Traditional IRA and then convert it to a Roth IRA.
How Do I Report the Backdoor Roth IRA in Turbotax?
After publication, a reader emailed asking this question. I haven’t created a guide walking you through each step for tax software but you want to make sure your Form 8606 looks right (see the Backdoor Roth IRA tutorial). If the Form 8606 isn’t filled out correctly, it’s possible that the tax software will try and tax you twice. The Finance Buff has some great visual guides for reporting in the various tax software. See them here: Turbotax Guide; H&R Block Guide; TaxAct Guide.
Let’s talk about it. This article covers the most frequent questions I’ve seen on the Backdoor Roth IRA. Let me know in the comments if you have additional questions. More importantly, make sure you understand the value of the Backdoor Roth IRA!
Joshua Holt A practicing private equity M&A lawyer and the creator of Biglaw Investor, Josh couldn’t find a place where lawyers were talking about money, so he created it himself. He spends 10 minutes a month on Personal Capital keeping track of his money. He's also exploring real estate crowdfunding platforms like Fundrise which are open to both accredited and non-accredited investors.