Avoid This Mistake When Funding a Backdoor Roth

Running afoul of the pro rata rule can negate much of the tax benefit.

The so-called “backdoor Roth IRA” is a powerful tool that allows higher-income taxpayers to fund Roth individual retirement accounts indirectly when income limitations would otherwise prevent them from contributing to a Roth. 

On the surface, the strategy seems simple enough: Fund a traditional IRA and convert those funds to a Roth. However, there are rules that must be followed and complications that must be considered when clients consider executing a backdoor Roth IRA funding strategy. 

While the Internal Revenue Service blessed the strategy as a legitimate option when the 2017 tax reforms were enacted, clients can still get into trouble if they don’t pay close attention to the rules of the game.

Backdoor Roth Strategy: The Basics

Under current law, income restrictions prohibit high-income taxpayers from contributing directly to a Roth account. Only clients who earn less than $240,000 (joint returns) or $161,000 (single filers) in 2024 can contribute directly to a Roth IRA. The ability to fund a Roth starts to phase out for clients earning as little as $146,000 (single) or $230,000 (joint returns)). 

Roth conversions, however, aren’t subject to an annual income limit.

In other words, taxpayers whose income is greater than the annual limits are still permitted to execute a backdoor strategy to fund a Roth via a series of transactions (generating current income tax liability in the process). The client accesses this “backdoor” by first contributing to a traditional IRA and subsequently executing a Roth conversion, paying taxes on the amounts converted. This allows the higher-income client to create a source of tax-free income for the future.

Remember, however, that the client (or a spouse) must also have earned income for the year to contribute to the traditional IRA in the first place. Clients should also be advised that for those who have not yet reached age 59.5, a five-year waiting period will apply before they are entitled to access the converted Roth funds without penalty.

Beware the Pro Rata Rule

The pro rata rule is a common trap that clients fall into when executing Roth conversions to fund a backdoor Roth. The pro rata rule applies if the client does not convert all of the funds in traditional, SEP and Simple IRAs at one time and the traditional IRA contains both deductible and non-deductible contributions. 

Remember, it’s common for a high-income client’s IRA to contain both deductible and non-deductible contributions because of the relatively low IRA pre-tax contribution limit ($7,000 in 2024). Non-deductible contributions can also lower the overall tax associated with the Roth conversion used to fund the backdoor Roth.

Basically, the pro rata rule requires that the proportion of pre-tax to after-tax contributions in the entire IRA pool be considered when determining how the backdoor Roth contribution is taxed (i.e., clients cannot choose to convert only after-tax contributions to avoid tax on the conversion if they are leaving pre-tax contributions in a traditional IRA). Each dollar that is contributed must contain a percentage of tax-free and taxable contributions. That percentage is based on the ratio of taxable to non-taxable contributions in the account as a whole.

That said, if the client also participates in an employer-sponsored 401(k), it may be possible to roll only the pre-tax IRA contributions into that 401(k), leaving only non-deductible contributions in the IRA.

Reporting and Technical Rules

Clients should also be reminded to keep good records and remember to file the appropriate tax forms. 

For example, taxpayers must report to the IRS when they make non-deductible contributions to a traditional IRA. Form 8606 is filed with their federal income tax return. When clients convert  the funds to a Roth, they will receive Form 1099-R in the following year. Form 5498 is used to report the conversion itself. When the client files a tax return, another Form 8606 must be completed to show how the pro-rata rule applied.

Conclusion 

It’s important to remember that it is the clients’ responsibility to keep track of the non-deductible contributions made to their IRA. Failure to maintain proper documentation and comply with reporting obligations can lead to penalties and negate some of the significant benefits of the backdoor Roth strategy. 

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