Back door entry to the Roth IRA?

Anyone can contribute to a Roth IRA, irrespective of their income. It is true that IRS has an income limit on who can contribute to the Roth IRA but it has a really neat (and simple) workaround.

For the year 2015, IRS rules (IRC – Internal Revenue Code, to be specific) specify that single filers making more than $131,000 and married filers filing jointly making more than $193,000 cannot contribute to Roth IRA.

Now here comes the neat trick and it has two parts - contribute to traditional IRA and do a Roth conversion.

Yes, it is that simple and achieves what you would have achieved by being able to contribute directly to a Roth IRA. Once the money is in Roth IRA, the money is there in the Roth IRA – irrespective of whether you made the contribution from your checking account or a rollover from your traditional IRA account.

Step-1: Make a contribution to traditional IRA (anyone with earned income can make a contribution to traditional IRA, there isn’t even an age limit). Earned income includes W-2 income, Self employment income from a business, Farming income, and alimony.

Back door entry to Roth IRA_ Traditional IRA statement

My Traditional IRA statement (2014), contribution made on 2/6 and Roth conversion happened on 2/23

You will not be able to take a tax deduction in the current year because the Roth IRA contribution income limit is higher than the income limit for the traditional IRA to be deductible . So, no tax deduction in the current year.

Step-2: Do a Roth conversion; rollover the money from your traditional IRA to your Roth IRA account. What about taxes? IRS rules are clear that only those monies that lead to a tax deduction at contribution will be taxed. Yes, you guessed it correctly – since your original contribution was not tax deductible, you do not owe any taxed on the rollover as far as the original contribution is concerned.

Back door entry _ Roth IRA statement

My Roth IRA statement, $5,500.02 received on 2/23

You do owe taxes on interest and earnings that money has generated while it was there in the traditional IRA account. If you contributed $5,500 to the traditional IRA and bought stock that has appreciated to being $6,000 now; then you do owe taxes on the $500 earnings.

But hey – you do not have to invest the $5,500 traditional IRA into stock, you can roll it over as soon as the contribution is made. Yeah, that is right. For 2015, I contributed $5,500 to my traditional IRA. The money was lying there for a couple of days and then I did a Roth conversion of $5,500.02.

You will receive a 1099-R at year end with distribution code (box 7) as ‘2’ and ‘IRA/SEP/SIMPLE’ also checked. This means you will not owe taxes on the ‘principal contributions you made to traditional IRA that you are rolling over’. You still will owe taxes on any earnings.

Back door entry _ 1099 R

1099-R was issued due to Roth Conversion

Usually IRA and Roth IRA accounts are at the same brokerage firm. In which case, the question of taking ‘cash distribution from the IRA and depositing the proceeds into Roth IRA’ does not arise. In case, your IRA and Roth IRA accounts are with different brokerage firms, try not to take the ‘money’ yourself, ask the IRA brokerage firm to do a trustee-to-trustee transfer and send the proceeds to the Roth IRA brokerage firm ->this way chances of an error (or delay or mishap) are minimized.

Tax calculations can get complex

Tax calculations can get complex if your traditional IRA has prior contributions that were tax deductible and/ or there are earnings present in the account.

When you rollover assets from IRA to Roth IRA, you cannot choose which assets to rollover. If your IRA has contributions on which you got tax deduction in contribution years and other contributions that were not tax deductible; you cannot just choose to rollover either of them. The rollover has to be pro-rated. There is no way to differentiate dollars within IRA account.

Let us take an example – Let us say your total current balance in IRA (2014 contributions and before) is $25,000 – let us say 20k is principal contribution and 5k is gains part. Let us say, all of the 20k was tax deductible (you contributed 5k each for 4 years and were able to deduct the 5k when you filed your taxes).

Now you contribute 5.5k more for 2015 today (non-deductible), so total balance becomes 30,500. Tomorrow you convert all of that into Roth, you pay taxes on 20k ‘deductible’ contributions and 5k (profit).

If you were to convert only 5.5k tomorrow….then following is the calculation: Total balance = 30,500 out of which 25,000 is ‘taxable’ – so 82% is taxable…. so 82 cents of every dollar is taxable. Now if you convert 5500, then 5500 *.82 = $5,210 is taxable.

So let us summarize what I did

There are tremendous tax advantages of making Roth IRA contributions. Due to my high income levels (luckily) I am ineligible to make direct Roth IRA contributions. So I first contributed the maximum allowable amount. And then I immediately did a Roth conversion!

This is a no-brainer for high income earners. At such high income levels, you definitely need to be saving sizable amounts for retirement; this way $5,500 of it can be in an account which is not taxed at withdrawal.

17 thoughts on “Back door entry to the Roth IRA?

    • Reagan, this is very real.

      After reading Bobby’s post, I have successfully completed this for myself. I feel sad that I did not know about this before, I should have done it every year.

    • I added some actual screenshots from my brokerage account – traditional IRA statement, Roth IRA statement, and the 1099-R issued at year end. Hopefully this will help too.

  1. I just found your site and really like it.
    Let me tell you a variation of this conversion that I used this year. My accountant worked this out for me.
    First, because I own a couple of small businesses ( one is a rental home) j was able to create 401(K) accounts for each of them.
    Next, I consolidated all of my traditional IRAs into one account. My non-deductible basis in IRAs had been tracked over the years and was $20,000.
    First I converted the value of my IRA, less the non-deductible basis, to my 401(K) account. That left the $20,000 non-deductible basis, with NO earnings, in my IRA.
    I then converted that remaining amount, $20,000, to my Roth IRA account with no taxes due because no earnings remained even though the money had been contributed many years earlier.
    I plan to make my annual IRA contributions and roll them over to the Roth IRA each year going forward in addition to making 401(k) contributions from my small business income.
    I hate paying my high-priced accountant to do my taxes each year, but his advice on this type of transaction makes him worthwhile.

    • Rod – good to have you on my site. The way you think and write makes me feel we are going to stay in touch for a very long time.

      What you did with your IRA and 401k is really cool – it is called reverse rollover. Being able to move the pre-tax dollars (and earnings) to 401k and moving only the after-tax dollars (non-deductible portion) to Roth IRA is really cool.

      The strategy would have just worked fine even if you did not consolidate all your traditional IRAs into one account. One can argue that ‘tax calculations’ become easier but in my opinion they remain the same. This step probably was unnecessary (consolidation). More so, because now you will use only one traditional IRA account going forward. You might have already seen how my Roth IRA reached 6 figures between 2011 and 2015 – http://wp.me/p6V9kv-eW

      About how much do these over priced accountants charge? Just curious….

  2. Hello Bobby,

    It’s flying off my head …Can you please let me know what Rod did in simple terms ? I have 2 rental properties … Should I open 2 LLC’s (one for each rental property ?) and create 2 401K accounts (one for each) … then after that what should I be doing ? Please let me know. Thanks.

  3. Hello,

    I am trying to open the tradiational IRA and move the funds to Roth IRA as stated above (ot required to pay taxes while withdrawing). But when I am trying to open the account below are restrictions to open Traditional IRA at Merrill Edge. But you were saying, there are no limits. Can you please help me.
    Reducing your current taxes
    Tax-deferred growth potential
    Investors under age 70½ with earned income
    Single tax filers earning less than $71,000 (2016)
    Joint tax filers earning less than $118,000 (2016)

    • Hi Surya – the things you mention are not restrictions. Specifically the ML site you are looking at says the following:

      May be a good move for…
      Reducing your current taxes
      Tax-deferred growth potential
      Investors under age 70½ with earned income
      Single tax filers earning less than $71,000 (2016)
      Joint tax filers earning less than $118,000 (2016)

      If you are under the age of 70 ½ and have earned income (you or your spouse), then you can contribute to a traditional IRA. (Additionally this contribution will be tax deductible if certain other conditions are met). Read here:

      http://onemoredime.com/2016/01/09/ira-versus-roth-ira/

  4. I have couple of questions –
    1) Per 1099-R your taxable amount is $5500. So ultimately you are paying taxes on those $5500? Am I correct?
    2) What is the advantage of having money in Roth IRA than brokerage account?

    • 1) 1099-R can be a little confusing, but in short – the way ‘taxable amount not determined’ is checked on the 1099-R and the Box 7 contains the Code 2, IRS knows that the distribution is not taxable.

      For details you can see “Roth IRA conversions” section here on the IRS website (but it gets confusing very soon): https://www.irs.gov/instructions/i1099r/ar02.html#d0e1685

      To summarize – I am not paying any tax on the $5,500….. zero.

      2. Advantage of having money in Roth IRA than a brokerage account – this one is simple. Roth IRA withdrawals are not taxed. So the $5,500 will become say $20,500 by my retirement. I will not pay any tax when I withdraw $20,500.

      But if this 5.5k becomes 20.5k in a brokerage account, then I will pay capital gains tax on the 15k in gains…. assuming 20% capital gains tax, that is $3,000 !

      • Thanks for the quick reply Bobby. I really appreciate it. I discover your blog on Monday and by now I have read almost each and every article you have written. You unfold the complicated stuff in simple language along with examples. That makes it very easy to understand. Thanks for the help.

  5. Great blog, very informative!

    A couples questions on the “Tax Calculations can get Complicated Section”:

    I have an existing traditional brokerage IRA with a long history of pretax deposits – so if I used that account for the back door Roth Conversion my taxable ratio would be high like in your example. Could simply just open a new traditional IRA account and keep a minimal balance in it to facilitate the Roth Conversions and minimize the taxable amount of my conversion?

    As a follow up, while researching my employers 401K plan, I discovered that I can roll after tax dollars out of the plan at any time. Given that I can contribute much more that $5500 in after tax funds to the 401K plan after tax, would it be prudent to skip the conversion method and just roll my after tax 401K deposits right into my existing brokerage Roth?

    Thanks!

    • Thank you.

      Opening a new traditional IRA will not help. ALL of your traditional IRA accounts need to be taken into account. So the number of traditional IRA accounts does not matter – two different accounts are exactly the same as one account (as long as the ‘contents’ are the same).

      Yes – you should use the 401k after tax rollover route. See here: My Roth IRA crosses $100,000 (2011 – 2015)

      • Amazing blog, thank you!
        I’d like to get a better grasp of this…I’m considering a Solo 401k to get the flexible plan design and investment options and would like to understand the strategies and what type of contributions can be distributed without penalty, should I need the cash.

        Can Roth contributions to a Solo 401(k) be distributed prior to age 591/2 penalty-free? Tax-free up to basis?
        Can after-tax nondeductible contributions be distributed penalty and/or tax free prior to age 59 1/2?
        Found this website very helpful https://www.401kcheckbook.com/checkbook-control/checkbook-control-401k/ , but seems that there’s a lot more complexity to this.

        Thank you!

        • There are a few hardship scenarios in which you can withdraw money from 401k without the penalty.

          There is also a possibility of taking a loan from your 401k.

          • Bobby,
            Thanks for the quick reply.
            Those features are available in the Solo 401k plan I’m considering.

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