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How NOT to do a Backdoor Roth Conversion - A Client Case Study


There are lots of articles out there touting the benefits of ‘backdoor’ Roth conversions.  Many of these articles will even ‘show’ you how to do them.  As straightforward as they might appear in a Forbes article, there are many things that might trip you up if you’ve never done a backdoor Roth conversion before. 

This article will explain: 

  • Difference between a traditional IRA and Roth IRA 

  • What a backdoor Roth conversion is 

  • A client story about a backdoor Roth conversion and some of the challenges we faced  

  • Considerations for your own backdoor Roth conversions 

The difference between a traditional IRA and Roth IRA 

Before we go in depth, it’s worth understanding what a backdoor Roth conversion is.  To understand this, we’ll take a step back to discuss the difference between three types of IRAs: 

  • Traditional IRA:  According to the IRS, a traditional IRA is any IRA that isn’t a Roth IRA or a SIMPLE IRA (employer-sponsored).  In layman’s terms, this is an account that you open, contribute earned income to, and invest on a tax-deferred basis.  Depending on your income and whether you have an employer-sponsored retirement plan at work, you may (or may not) be able to deduct your IRA contribution from your taxable income when you file your annual tax return.  However you invest your IRA contributions, your earnings are tax-deferred.  In other words, you don’t get taxed on earnings while they’re in the IRA.  When you eventually withdraw your money, the distributions are considered to be taxable as ordinary income.  Unless you meet certain eligibility criteria, you may also be subject to a 10% penalty on distributions made before age 59 ½.   

  • Roth IRA:  Pretty much the opposite of a traditional IRA.  Instead of being able to deduct your contributions, you make your contributions with after-tax money (earnings you already paid taxes on).  In exchange, you are able to receive qualified distributions on a tax-free basis. 

  • Nondeductible IRA:  Technically, a nondeductible IRA is a traditional IRA, in which you were not able to deduct contributions on your tax return.  Otherwise, treated like a traditional IRA—tax deferred earnings, taxable distributions.   

Big picture:  Traditional IRA = pre-tax money goes in, pay taxes on the way out 

   Roth IRA = after-tax money goes in, don’t pay taxes on the way out 

However, there are some other differences worth noting.  Although most of those differences are outside the scope of this article, the IRS has a nice side-by-side chart comparing Roth and traditional IRAs.   

What is a backdoor Roth conversion? 

 So, to understand what a backdoor Roth conversion is, we must first understand what a Roth conversion is.  Simply put, a Roth conversion is where you take money from a traditional IRA, pay any necessary taxes on it, then transfer it into a Roth IRA.   

Why would you do this?  Primarily because you are in a lower tax bracket (or you believe that you are) than you might be down the road.  The theory is that if you pay your taxes while you’re in a lower tax bracket, then you’ll pay less in taxes over the course of your life.  Of course, to go further would require more in depth discussion (again, not the focus of this article). 

A backdoor Roth conversion is a conversion of money from a nondeductible IRA (similar to an IRA, but the contributions were not deducted from your tax return.  This mostly appeals to people who cannot make a direct Roth contribution in the first place, due to income reasons.  The steps are fairly straightforward: 

  1. Open and contribute to a nondeductible IRA.  Since the contributions are nondeductible, you don’t have to do anything special on your tax return, except fill out Form 8606, Nondeductible IRAs.     

  1. Do a Roth conversion from your nondeductible IRA.  Your custodian can usually help you with the paperwork.   

That’s really it.  But, the devil is in the details. 

  1. Backdoor Roth conversion:  Just the term, ‘backdoor’ implies that there’s something sneaky.  After all, if you’re doing something that amounts to a Roth contribution, but requires additional steps, that appears to be something the IRS would catch on to and squash.  Indeed, that is what used to happen.  However, one result of the Tax Cuts and Jobs Act (TCJA) was that Congress recognized and legitimized backdoor Roth conversions in the TCJA Conference Report (footnotes 268 and 269).  So, whatever the IRS used to say about backdoor Roth conversions, they’re here to stay, thanks to Congress. 

  1. IRA aggregation rules & pro-rata distributions of non-deductible IRA contributions:  Simply put, if you have an IRA (or multiple IRAs) with deductible (pre-tax) and non-deductible (after-tax) contributions, then you have to aggregate & pay taxes on a pro-rata basis for any Roth conversions from both pre-tax and after-tax dollars.  In other words, let’s imagine you have $100,000 in IRA contributions.  ½ are in a traditional IRA, where you deducted the contributions on your tax return each year.  ½ are in a non-deductible IRA, where you paid taxes on the contributions, but reported them each year on Form 8606 like you’re supposed to.  You would be inclined to do a Roth conversion on only the $50,000 that you already paid taxes on.  But you can’t.  If you do a $50,000 Roth conversion, you would have to take the appropriate amount of pre-tax AND after-tax IRA contributions, which would amount to paying taxes on $25,000 in pre-tax contributions.  Even if they are in two separate accounts, the IRA aggregation rule forces you to consider all contributions as if they’re in one account. 

  1. Exception to the aggregation rule:  This only applies to IRAs.  It does not apply to contributions to an employer-sponsored retirement plan.  This is a key distinction.   

There are a few more complexities to Roth conversions, but these are the ones that pertain to this client story. 

Client Roth Conversion Story 

One of our doctor clients, who is a really good saver, had been maxing out her employer-sponsored work plans and had been making non-deductible IRA contributions for several years.  During a meeting, she asked about doing a backdoor Roth conversion with her non-deductible contributions. 

Unfortunately, the IRA where those contributions had been going (for several years) was also the same IRA that was a rollover from an old 401(k).  There were about $105,000 in pre-tax contributions and only about $38,000 in non-deductible contributions.  This meant that to be able to get the full $38,000 converted tax-free, she would have to pay taxes on the other $105,000.  Being in a single doctor’s tax bracket, that just did not make sense. 

The additional challenge was that the non-deductible and deductible contributions were in the same account.  This means that we would have to identify the non-deductible contributions and somehow separate them from the deductible ones before we could even begin a Roth conversion. 

Finally, this would only work on a tax-free basis if she participated in an employer-sponsored retirement plan that allowed transfers into the plan, which not all employers do.  Fortunately, she was a participant of the government’s Thrift Savings Plan (TSP), which allows transfers into their plan.  Not only that, but the IRS  

Why is this important?  Because of this:   

The only way to circumvent the IRA aggregation & pro-rata rules is to ensure that 100% of your IRA contributions are non-deductible ones.  And the way to ensure that is to roll the pre-tax funds out of your IRA, and into the employer-sponsored plan, if it accepts rollovers into the plan.  Since the pro-rata rules do not apply to rollovers into a pre-tax employer-sponsored plan (like a 401k), that leaves the non-deductible contributions in the IRA—if done properly.  After that, all that remains is to convert those contributions (which you’ve already paid taxes on) into a Roth IRA, tax-free. 

To avoid keeping you in suspense, we did this successfully.  But it took a lot of work, and coordination with her accountant.  Fortunately, since we (our firm and the accountant) kept good records, we were able to go back into our client files.  From there, we determined how much of our client’s contributions had been non-deductible IRA contributions, and how much were originally rollovers from previous employer plans.  We identified the $38,000 in original non-deductible contributions, then transferred the rest into her TSP account.  The $38,000 then became our client’s Roth conversion. 

Lessons Learned 

  1. The importance of keeping good records.  Most of the time, your financial planner or custodian will have records that go pretty far back.  However, when you have 20 or 30 years of investment history (which many people in their fifties do), odds are that you might not be with the same advisor.  Or the custodian you used to work with got bought by a bigger outfit that doesn’t have those records anymore.  The only person you can rely upon to keep good records over long periods of time is you. 

  1. Keeping separate accounts for a non-deductible and deductible IRA.  Anyone who already has an IRA should establish a separate IRA in the first year they plan to make a non-deductible contribution.  Even if you don’t make a Roth conversion that year, this will make it so much easier to identify how much of your IRA was from your non-deductible contributions (which you shouldn’t pay taxes on when you convert).   

  1. Don’t shut the door on your employer plan once you leave your job.  At least, take a look at your plan document to see if that plan accepts after-tax contributions.  That’s the key to being able to isolate non-deductible contributions from your pre-tax ones.  The Thrift Savings Plan is ideal because it accepts after-tax contributions, has plenty of diversification, AND has some of the lowest costs of any plan out there!  This conversion scenario was only available to our client because she kept her TSP account after she left her government job. 

  1. Sometimes, you can’t do this on your own.  Our client probably could have done this on her own.  However, being a doctor, this probably would not have been a priority.  And if she ever had the time to actually take the steps to do this, she would have had to take even more time just to learn the steps involved.  Fortunately for her, she hired an accountant and a financial advisor to take care of this for her.   

  1. It takes a team.  More importantly, her accountant and financial advisor actually work together as a team.  As her financial advisor, we engage in annual tax planning.  We share client information with the accountant (and vice versa), with the client’s permission.  Before we do anything that might create a significant taxable event, we coordinate with her accountant and get their okay.  Then, at year’s end, we give the accountant a lot of information so it’s easier for them to prepare the client’s tax return.     

Conclusion 

There is plenty of online advice that tells you the simple steps involved in a Roth conversion.  And for many people, it can be that simple.  But not for everyone.     

The tough part is finding out that you missed something that you really should have paid attention to.  This case study is just one of MANY ways that a Roth conversion can go awry, if you don’t pay attention to the details.  And if you don’t have the experience, education, or the time to learn, you might consider hiring a tax-focused financial advisor to help you with your Roth conversion options.