Avoid These Mistakes with Backdoor Roth IRAs

In 2010, Congress repealed the aggregate income limit that had previously been placed on Roth IRA conversions. This adjustment allowed many taxpayers who were previously unable to convert their traditional IRA and qualified plan balances to do so without restriction. It also created a tax loophole for those with Adjusted Gross Income's that were too high to permit direct Roth IRA contributions. High-income taxpayers could now do so by simply making their annual contribution to a nondeductible traditional IRA and then converting it to a Roth each year. Although Congress did not intend to allow this form of “backdoor” contribution, it is perfectly legal under current tax law. However, several rules need to be followed in order to do this correctly, and those who use this strategy need to be sure to avoid several common errors. (For more, see: Is a Backdoor Roth IRA Suitable For You?)

Mistakes to Avoid

  • Over-Contributing – Although the backdoor Roth contribution strategy is permissible in the tax code, all of the other standard rules still apply. You cannot make pass-through contributions in excess of the standard limits for a given year; in 2015, you cannot put more than $5,500 into your Roth unless you are age 50 or above. If you are, then you can contribute another thousand dollars until the tax filing deadline for the year.
  • Letting the Money sit in the Traditional IRA – Although there is no tax rule against this, the backdoor conversion strategy can be done most straightforwardly by immediately converting the contribution balance to the Roth account. There is no point in allowing the money to sit in the traditional account and accumulate interest, dividends or other forms of income, because you cannot move that money into the Roth account if you are making the maximum possible contribution. That money would instead have to stay in the traditional account and be subject to the tax rules for traditional IRAs.
  • Ignoring the Pro-Rata Exclusion Rule – There is a somewhat complicated set of rules that comes into play when this strategy is used by taxpayers who also have other existing traditional IRA balances. When this is the case, the taxpayer will owe ordinary income tax on the percentage of the conversion that equals the ratio of IRA assets that have already been taxed to the amount of pretax IRA assets. Those who do not pay attention to this rule may be forced to file amended tax returns that include the taxable amount of the conversion as income. (For more, see: How Can I Fund a Roth IRA If My Income is Too High To Make Direct Contributions?)
  • Failing to do a Re-Characterization if You Made the Previous Mistake – If you used the backdoor contribution strategy and failed to make the ratio calculation as described above, or if you did make the calculations and the tax bill proves to be too burdensome, then you can undo your conversion by re-characterizing that money as a traditional IRA contribution and moving it back into that account.
  • Failing to Use the Rollover Strategy – Taxpayers who already have traditional IRA balances may be able to avoid the previously-described scenario if they are making contributions to an employer-sponsored qualified plan. If their plan charter permits them to roll other tax-deferred plans or IRAs into their current plan, then they can roll all of their outstanding traditional IRAs into their employer’s plan and thus exempt those assets from the taxable ratio calculation. This is possible because qualified plan balances are not included in this ratio.
  • Using the Rollover Strategy Irrelevant of Other Factors – Although the rollover strategy may simplify your finances and reduce your tax bill, don’t use it if your company’s retirement plan does not offer sound investment choices or charges excessive fees. Be sure that you will be able to get a decent return on that money before rolling it into your plan.
  • Simple Failure to Use this Strategy – If your income is too high for you to be able to make direct Roth contributions, then this tax loophole is your only chance to accumulate a pool of tax-free cash over your lifetime. This is especially true if you are not allowed to make Roth contributions in your employer-sponsored qualified plan. Any tax or financial advisor will tell you that you are virtually guaranteed to come out ahead in the end by taking advantage of this strategy. (For more, see: How Does a Roth IRA Grow Over Time?)
  • Waiting Around on Congress – Obama included a provision in a recent tax proposal that would close this tax loophole. Don’t wait to see what happens with this before making your conversion. Even one year of conversion money growing tax-free can grow into a significant amount over time. And most financial legislation that gets passed only applies to future transactions and not those already completed.

The Bottom Line

The backdoor Roth conversion strategy is probably not going to be around forever. Don’t delay in using it if you cannot get money into a Roth plan or account in any other way, but be sure to follow the rules and properly document your transaction. (For more, see: I Maxed Out My IRA! Now What?)