A little more than a year ago, there was an aggressive effort in Congress to eliminate “back door” Roth IRA strategies.
The effort failed. The back door Roth IRA strategies remain available to create a future stream of tax-free gains and income.
A back door Roth IRA strategy is necessary in two situations, and there are two strategies to consider.
One situation is when a higher-income taxpayer wants to contribute to a Roth IRA. The tax code limits Roth IRA contributions in 2023 when adjusted gross income exceeds $138,000 for single taxpayers and $218,000 for other taxpayers.
The other situation is when a taxpayer wants to build a Roth IRA balance faster than is possible with the maximum $6,500 annual IRA contribution limit. ($7,500 for taxpayers ages 50 and over.) This taxpayer might also exceed the income limit for Roth IRA contributions.
The first back door Roth IRA strategy begins with a nondeductible contribution to a traditional IRA.
The contribution isn’t deductible, because the taxpayer’s income exceeds the limit for deducting traditional IRA contributions and the taxpayer has access to an employer retirement plan. After money is contributed to a traditional IRA, the taxpayer waits a while and then converts the traditional IRA to a Roth IRA.
The nondeductible contribution that is converted will not be taxed, because it already is after-tax money. Only any accumulated income and gains would be taxed on the conversion. The taxpayer now has a Roth IRA instead of a traditional IRA.
There are three caveats. The first caveat is to be sure the conversion is done by a rollover from one trustee to another (or by having the same IRA trustee move the money directly from the traditional to a Roth IRA).
You don’t want to take possession of the account balance and transfer it to a Roth IRA. If you take possession, you must complete the rollover within 60 days.
Also, you’re allowed only one 60 day rollover every 12 months. It is safer to have the IRA custodians handle the transfer.
The second caveat is that you shouldn’t already have a traditional IRA with pre-tax money (deductible contributions). When you convert only part of your aggregate traditional IRAs, the IRS requires you to make a pro rata conversion of the pre-tax and after-tax money in all the IRAs.
You won’t be able to roll over only the new after-tax money and leave all the pre-tax money in the pre-existing IRAs.
The third caveat is that you should wait a while after making the non-deductible contribution before doing the conversion. The IRS hasn’t issued specific rules on this back door Roth IRA.
It is possible the IRS would argue that a conversion made soon after a nondeductible IRA contribution really is a Roth IRA contribution in disguise.
The IRS could say the series of transactions should be considered as one transaction and the Roth IRA is disqualified. It is not clear how long you should wait before doing the conversion, but the longer you wait the safer you are.
The second back door Roth IRA strategy requires the use of a 401(k) plan with your employer or a solo 401(k) if you’re self-employed.
You might have seen this referred to as the Mega Roth IRA or Mega Back Door Roth IRA. For the strategy to work, the 401(k) plan needs to allow additional after-tax contributions by employees who maximized their pre-tax contributions ($22,500 in 2023 plus an additional $7,500 catch-up contribution for those 50 and older).
The tax law allows additional after-tax contributions, though many people don’t know it. The maximum total contribution to a 401(k) for a worker is $66,000 in 2023 or $73,500 for those 50 and older. The maximum includes pre-tax contributions, employer contributions and after-tax contributions.
That means someone 50 or older might be able to make up to $43,500 of after-tax IRA contributions in 2023. The other provision the 401(k) plan should have allowed in-service distributions without a showing of financial hardship.
An in-service distribution is one made while the employee still works for the employer. Most of the time, a 401(k) distribution is allowed only after a worker retires, moves to another employer, dies, or becomes disabled. Most plans that allow in-service distributions permit them only after age 55.
When your 401(k) plan has the two key provisions, you can make after-tax contributions to your account. After the contributions have accumulated, you execute an in-service distribution by having the after-tax contributions rolled over tax free to a Roth IRA.
Once the money is in the Roth IRA, it is treated the same as any other Roth IRA money. Have the rollover done directly between the plan administrator and the Roth IRA custodian.
Most 401(k) plans limit the number of annual in-service distributions. It’s best to keep things simple and do one in-service rollover distribution per year.
You can roll over to the Roth IRA only after-tax contributions. Any income and gains accumulated in the account shouldn’t be transferred to a Roth IRA.
Most plan administrators keep good records of after-tax contributions. If yours doesn’t, you’ll have to be able to prove the amount of the after-tax contributions.
The change still can be executed if your plan doesn’t allow in-service distributions. The difference is the after-tax contributions can’t be rolled over to the Roth IRA until after you separate from the service of the employer.
You’ll be more likely to have accumulated investment income and gains in the account, so you’ll have to be sure only the after-tax amounts are rolled into the Roth IRA.