Our clients typically turn to their 401(k) account as the vehicle to maximize tax-advantage savings and ask the following questions:
1) How much money did I contribute last year?
2) Was my contribution made through a pre-tax account, or a Roth 401(k)?
3) Did I make an after-tax contribution?
4) Is it in my budget to contribute more this year?
5) Did my employer make any changes to my plan?
6) Have the employee contribution caps increased since the 2017 tax year?
(Note: Maximum 401(k) contributions of $18,500 for pre-tax or Roth with a $6,000 catch-up contribution limit.)
What is a Backdoor Roth IRA Contribution?
We agree that the 401(k) is a very important part of retirement savings, however, many clients forget about Traditional IRAs and Roth IRAs. Many think that the maximum income threshold for married couples filing jointly to contribute to a Roth IRA (during the 2017 tax year) is $196,000 and that the tax deductibility phase out limit for a Traditional IRA ranges from $99,000 - $119,000, if covered by a plan at work.
While these limits are prominent in IRS tables, we want to steer your attention to the lesser-known Backdoor Roth IRA contribution strategy. As a broad overview, there are no income limits with this strategy. Additionally, the Backdoor Roth IRA contribution strategy marries a contribution to a non-deductible IRA with a conversion to a Roth IRA.
This strategy allows you to save up to $6,500 annually per person (including spouses), over and above what you are already contributing to your employer’s 401(k). Many investors can still contribute $6,500 for the 2017 tax year (as long as the contribution is made before filing the 2017 tax return) in addition to contributing for the 2018 tax year. If you are married, that means $13,000 in additional retirement plan savings for 2017 and an additional $13,000 for 2018, for a total of $26,000 in additional retirement savings.
What Should You Consider Before Making a Backdoor Roth IRA Contribution?
Before a saver can begin utilizing the Backdoor Roth IRA strategy, it is important to ensure that they do not have any pre-tax money in IRAs. Upon completing a Roth Conversion, an individual moves the money from an IRA to a Roth, and will pay taxes on any pre-tax money that was converted. If you only have non-deductible money in your IRA, this is not an issue.
The dilemma: If you have pre-tax money in any of your Roths, it’s important to understand the pro-rata rule and its stipulation that all IRAs are treated as one IRA. So, how can the pro-rata rule affect the outcome of using a Backdoor Roth IRA strategy? Let’s walk through an example of the consequences one may face upon completing a Backdoor Roth IRA contribution without proper planning:
Max has an IRA at Vanguard that contains $93,500 of pre-tax funds. He decides he wants to do a Backdoor Roth IRA contribution, so he opens an IRA at Fidelity. Max contributes $6,500 of non-deductible money and immediately proceeds to convert the money to his Roth IRA at Fidelity. Max thinks that he will not owe any taxes on the conversion because he converted money from his Fidelity IRA to his Fidelity Roth IRA. However, he did not understand the pro-rata rule before making this financial decision.
The pro-rata rule says that all IRAs are treated as one IRA for the purposes of Roth Conversions. So, in reality, Max has $6,500 of non-deductible money across his IRAs and $93,500 of pre-tax money. In other words, 6.5% of the funds in Max’s IRAs are non-deductible, and the other 93.5% of the funds are pre-tax. So, of the $6,500 Roth conversion 6.5% is tax-free; the other 93.5% is taxable at ordinary income rates!
You may be saying to yourself, “I have pre-tax money in IRAs, does this mean that I cannot utilize the Backdoor Roth IR contribution strategy without incurring negative consequences?" For the majority of our clients, the answer is probably not. However, these individuals generally require some consolidation of accounts before applying the Backdoor Roth IRA Contribution strategy to their own financial plan.
Our clients are primarily corporate executives and professionals, many of whom are still working in corporate America and have a 401(k) plan with their employer. Employer plans are not considered part of the pro-rata rule. So, if Max were our client, we may decide to consolidate his pre-tax IRAs to his company’s 401(k) plan. After we consolidated the $93,500 of pretax money into Max's company’s 401(k), then we could assist him in making a Backdoor Roth IRA Contribution because he no longer has any pre-tax IRA money.
We want to emphasize this strategy as one to discuss with a financial professional in early 2018, as its use may help you achieve your financial goals.