Backdoor Roth IRA Contribution Strategy
This strategy is for high income earners that make too much to contribute directly to a Roth IRA. In recent years, some of these high income earners have been implementing a “backdoor Roth IRA conversion strategy” to get around the Roth IRA contribution limitations and make contributions to Roth IRA’s via “conversions”. For the 2020 tax year, your
backdoor roth ira strategy
This strategy is for high income earners that make too much to contribute directly to a Roth IRA. In recent years, some of these high income earners have been implementing a “backdoor Roth IRA conversion strategy” to get around the Roth IRA contribution limitations and make contributions to Roth IRA’s via “conversions”. For the 2025 tax year, your ability to make contributions to a Roth IRA begins to phase out at the following AGI thresholds based on your filing status:
Single: $150,000
Married Filing Jointly: $236,000
Married Filing Separately: $0
However, in 2010 the IRS removed the income limits on “IRA Conversions” which open up an opportunity……if executed correctly…….for high income earners to make “backdoor” contributions to a Roth IRA.
Why would a high income earning want to contribute to a Roth IRA? Once high income earners have maxed out their contributions to their employer sponsored retirement plans, they usually begin to fund plain vanilla investment management accounts or whole life insurance policies. When assets accumulate in an investment management account, once liquidated, the account owner typically has to pay either short-term or long term capital gains on the appreciation. For whole life insurance, even though the accumulation is tax deferred, if the policy is surrendered, the policy owner pays ordinary income tax on the gain in the policy.
With a Roth IRA, after tax contributions are made to the account and the gains in the account are withdrawn TAX FREE if the account owner at the time of withdrawal is over the age of 59½ and the Roth IRA has been in existence for 5 years. A huge tax benefit for high income earners who are typically in a medium to higher tax bracket even in retirement.
Here is how the strategy works
Rollover all existing pre-tax IRA’s into your employer sponsored retirement plan
Make a non-deductible contribution to a Traditional IRA
Convert the Traditional IRA to a Roth IRA
Here are the pitfalls in the execution process
Over the years, more and more individuals have become aware of this wealth accumulation strategy. However, there are risks associated with executing this strategy and if not executed correctly could result in adverse tax consequences.
Here are the top pitfalls:
Forget to aggregate Pre-Tax IRA’s
Do not understand that SEP IRA’s and Simple IRA’s are included in the Aggregation Rule
They create a “step transaction”
Pitfall #1: IRS Aggregation Rule
The IRA aggregate rule stipulates that when an individual has multiple IRAs, they will all be treated as one account when determining the tax consequences of any distributions (including a distribution out of the account for a Roth conversion).
This creates a significant challenge for those who wish to do the backdoor Roth strategy, but have other existing IRA accounts already in place (e.g., from prior years’ deductible IRA contributions, or rollovers from prior 401(k) and other employer retirement plans). Because the standard rule for IRA distributions (and Roth conversions) is that any after-tax contributions come out along with any pre-tax assets (whether from contributions or growth) on a pro-rata basis, when all the accounts are aggregated together, it becomes impossible to just convert the non-deductible IRA.
picture
If an individual has pre-tax IRA’s we typically recommend that they rollover those IRA’s into their employer sponsored retirement plans which eliminates all of their pre-tax IRA balance and then open the opportunity to execute this backdoor Roth IRA contribution strategy.
Pitfall #2: SEP IRA & Simple IRA's count
Many smaller companies and self-employed individuals sponsor SEP IRA’s or Simple IRA Plans. Many individuals just assume that these are “employer sponsored retirement plans” not subject to the aggregation rules. Wrong. In the eyes of the IRS these are “pre-tax IRA’s” and are subject to the aggregation rules. If you have a Simple IRA or SEP IRA, make sure you take this common pitfall into account.
Pitfall #3: Beware IRS Step Transaction Rule
This is probably the most common pitfall that we see when executing this strategy. Individuals and investment advisors alike will make deposits to the non-deductible traditional IRA and then the next day process the conversion to the Roth IRA. In doing this, you run the risk of creating a “step transaction”.
There is a very long explanation tied to “step transactions” and how to avoid a “step transactions” but I will provide you with a brief summary of the concept.
Here it is, if you use legal loop holes in the tax system in an obvious effort to side step other IRS limitations (like the Roth IRA income limit) it could be considered a “step transaction” by the IRS and the IRS may disallow the conversion and assess tax penalties.
Disclosure: Backdoor Roth IRA Conversion Strategy
It is highly recommend that you work closely with your financial advisor and tax advisor to determine whether or not this is a viable wealth accumulation strategy based on your personal financial situation.
Michael Ruger
About Michael……...
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.
What is the 60 Day Rule and How Should it be Used?
The 60 day rule refers to the length of time an individual has to deposit money back into a retirement account that was previously withdrawn without incurring a taxable event. There are a number of reasons someone would withdraw money from an account whether it be to pay a large tax bill, obtain cash for an unexpected expense, or to rollover the
60 day rollover
The 60 day rule refers to the length of time an individual has to deposit money back into a retirement account that was previously withdrawn without incurring a taxable event. There are a number of reasons someone would withdraw money from an account whether it be to pay a large tax bill, obtain cash for an unexpected expense, or to rollover the balance into another retirement account.
There are multiple ways to rollover a balance from one retirement account to another so we will begin by explaining the more common ways to rollover a balance where the 60 day rule won't come into play.
Direct Rollover
A direct rollover is a transfer from a retirement plan to another retirement plan or IRA where the custodian of your current plan makes payment directly to your new account. This can be in the form of a check made payable to the new account custodian or a direct wire transfer. This method will avoid taxes and penalties because the account owner never had access to the cash during the transfer.
Trustee to Trustee Transfer
Similar to the direct rollover, a trustee to trustee transfer moves money from one IRA to another IRA without the account owner ever having access to the cash and therefore avoiding taxes and penalties.
The direct rollover and trustee to trustee transfer methods both avoid taxes and penalties as cash is never available to the owner and therefore the 60 day rule does not come into effect. In any case where the account owner has access to the cash, the money will have to be redeposited into another retirement account within 60 days or the owner will be taxed on any pre-tax dollars and possibly penalized if the owner is under the age of 59 ½.
The 60 day rule is one of the only ways an owner has access to money in a retirement account without paying taxes or penalties on the distribution. An individual can take advantage of this if they are in need of immediate cash for something like an unexpected expense. The distribution is essentially an interest free loan from your retirement account for 60 days. If the money is not available within the 60 days to redeposit, taxes and possible penalties will be assessed on the distribution.
IRS: One 60 Day Rollover in 12 Month Rule
The IRS recognized that individuals were taking advantage of this rule by taking multiple distributions in a single year and therefore increasing the time period. Beginning after January 1, 2015, the IRS changed the law to state that only one rollover can be made from one IRA to another IRA within a 12 month period. This rule does not apply to the following:
rollovers from traditional IRAs to Roth IRAs (conversions)
trustee-to-trustee transfers to another IRA
IRA-to-plan rollovers
plan-to-IRA rollovers
plan-to-plan rollovers
It shows the one rollover in a 12 month period rule was meant to limit the abuse of the 60 day rule because direct rollovers and trustee to trustee transfers are excluded.
What can be Rolled Over?
Most of the time the entire balance in a retirement account can be rolled over to another account unless the balance includes an amount of money that is required to be withdrawn. Examples include required minimum distributions and contributions in excess of limits (plus earnings on the excess contributions). For retirement plans, in addition to RMD's and excess contributions, any loans outstanding at the time of rollover or hardship distributions taken during the year will be subject to taxes and possible penalties.
Are Taxes Assessed at the Time of Distribution?
Distribution from an IRA: Typically, a tax is not assessed on a distribution from an IRA unless the account owner elects to have taxes withheld. A distribution from a pre-tax IRA account is typically subject to a 10% early withdrawal penalty if taken before 59 ½.
Distribution from Retirement Plan: Any distribution taken from a retirement plan where cash is made available to the owner is subject to a minimum 20% federal withholding. For example, if you request a $10,000 distribution, you will receive $8,000 and $2,000 will go to the government. There is no option to opt out of this withholding even if you intend to rollover the balance within 60 days. For this reason, a direct rollover would be a way to avoid the 20% withholding.
It is important to understand if you intend to rollover a distribution from a retirement account that the entire amount of the distribution must be redeposited within 60 days to avoid taxes and penalties even if taxes were already withheld. Using the previous example, if you take a $10,000 distribution from a retirement account and have the 20% withheld for taxes you must redeposit $10,000 within 60 days even though you only received $8,000 in cash. This scenario may appear that you are losing $2,000 but when you complete your taxes the $10,000 distribution will not be taxable as long as the full amount was redeposited within 60 days. When you file your taxes, the $2,000 will be included in the federal taxes withheld which is how the money is recouped.
How is the Rollover Reported to the Government?
Any time you wish to utilize the 60 day rule, it is important you keep documentation. Any distribution from a retirement account will generate a 1099-R form that must be reported as income on your tax return. Also, the 1099-R will show any taxes withheld from the distribution. You will receive a 1099-R even if a direct rollover or trustee to trustee transfer was done. The way the distribution is coded determines how the IRS treats it for tax purposes. If the distribution is coded as a direct rollover or trustee to trustee transfer, the distribution will not be treated as taxable income. If the distribution gave you access to cash, the 1099-R will be coded in a way that treats the distribution as a taxable event. If you redeposited the amount into another retirement account within 60 days, it is important you notify your tax preparer and bring documentation showing the deposit was made timely. The tax preparer should then treat the distribution as a non-taxable event.
About Rob.........
Hi, I'm Rob Mangold. I'm the Chief Operating Officer at Greenbush Financial Group and a contributor to the Money Smart Board blog. We created the blog to provide strategies that will help our readers personally , professionally, and financially. Our blog is meant to be a resource. If there are questions that you need answered, pleas feel free to join in on the discussion or contact me directly.
