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Investing Specialists

Want Another Shot at a 'Backdoor' Roth IRA?

There's a workaround for some high-income investors with sizable Traditional IRA balances.

Every article about the backdoor IRA maneuver--a way for high-income investors to fund a Roth IRA despite income limits--should carry two asterisks. 

The first should tell you to think twice about using the backdoor maneuver if you have a lot of Traditional IRA assets, because you could trigger an unexpectedly high tax bill. But the second should say that there's a workaround for investors who are participating in a 401(k) plan that allows "roll-ins." By rolling their Traditional IRA assets into their current employer's plan, the investor can avoid the tax hit that would otherwise accompany the conversion. 

The Backdoor Maneuver
Before we delve into the workaround, let's review who might consider a backdoor IRA and how it works. First of all, the backdoor Roth is only going to be of interest to high-income earners. If you're a single taxpayer who had between $114,000 and $129,000 in modified gross income in 2014, or if you're part of a married couple filing jointly with between $181,000 and $191,000 in MAGI for 2014, you can go into a Roth IRA through the front door, making a direct contribution to a Roth IRA. Those income bands increase a touch in 2015, to $116,000-$131,000 for single filers and $183,000-$193,000 for married couples filing jointly. (This article details the contribution and income limits that apply to IRAs for 2015.) 

But if your modified adjusted gross income is higher than the upper limits of those ranges, you earn too much to make any sort of direct Roth IRA contribution. In that case, your best option is to go in through the back door by opening a Traditional nondeductible IRA and then converting it to a Roth IRA shortly thereafter. This is a legitimate move because people at any income level can contribute to a Traditional nondeductible IRA, and income limits do not apply to conversions, either. 

And assuming you conduct the conversion shortly after you funded the Traditional nondeductible IRA, the move should be tax-free, or close to it. That's because you funded the IRA with money that has already been taxed, and your IRA hasn't had time to gain in value (provided you converted it to Roth shortly after opening), so you won't be taxed on any investment earnings, either. You're off to the races with your new Roth IRA: Your investment earnings will compound on a tax-free basis, you'll be able to take tax-free withdrawals in retirement, and you won't be required to take required minimum distributions from that account. 

The First Asterisk
That said, the backdoor IRA maneuver won't be a low- or no-tax tactic in every situation. For those investors who already have sizable balances in Traditional IRAs consisting of pretax dollars--for example, money rolled over from the 401(k) of a former employer--the conversion of a Traditional nondeductible IRA to a Roth may, in fact, trigger taxes. And the taxation of the conversion may undermine the tax-saving benefits of having the Roth IRA. 

That's because the IRS uses a special rule--called the pro-rata rule--when determining what portion of an IRA conversion or withdrawal is taxable. Specifically, the rule looks at all of an individual's Traditional IRAs as one big kitty, and any time part of that total balance is converted, the tax due is determined by looking at the ratio of monies that have not yet been taxed (deductible or pretax contributions plus investment earnings) to the total dollars in IRAs. If the never-been-taxed monies form the bulk of the IRA, a conversion won't be such a good move. 

Say, for example, an investor has steered $5,500 into a new Traditional nondeductible IRA hoping to convert that sum to a Roth. But if she already has $80,000 in a Traditional IRA consisting of pretax dollars and investment earnings, more than 90% of her nondeductible IRA would be taxable when she converts it to a Roth. That tax hit may drag on the long-term benefits of having the Roth assets in the first place. 

And the Second Asterisk
Does that mean high-income investors with high Traditional IRA balances should automatically avoid the backdoor Roth IRA maneuver? Not necessarily. Assuming the investor can contribute to a company retirement plan that also allows him or her to roll in assets from an IRA, the portion of the IRA that consists of deductible contributions--either because the money got into the IRA through a 401(k) rollover or because the investor made a direct IRA contribution and deducted it on his or her tax return--can be rolled into the 401(k). Doing so effectively removes those never-been-taxed monies from the calculation used to determine the taxes due on the conversion of the nondeductible IRA. Alternatively, investors who have some form of self-employment income might consider setting up a solo 401(k) and rolling the pretax IRA assets into that account. 

There are a few key issues to be aware of if you do a roll-in into your 401(k), however. The first is logistical: You can only roll pretax dollars into a 401(k); you cannot roll aftertax dollars into a 401(k). The second consideration is more qualitative: How good is the 401(k) plan that will be the receptacle for your Traditional IRA assets? While rolling your pretax IRA assets into a 401(k) will help you escape taxation on the backdoor maneuver, you better be sure that you won't incur additional costs or degrade the quality of your total investment plan in the process.

True, 401(k)s may offer better legal protections than IRA assets; they may also feature very low-cost investments. Additionally, 401(k) assets may be withdrawn under certain circumstances at age 55, whereas IRA investors must wait until age 59 1/2 to avoid triggering the 10% early-withdrawal penalty. 

But 401(k) plans may also feature an extra layer of administrative expenses that you can circumvent with an IRA. In addition, 401(k)s vary widely in the quality of their underlying investments. Some employers--especially, though not always, large firms--feature gold-plated lineups of ultra-low-cost funds and employ a cadre of investment professionals to oversee them; other 401(k) plans, meanwhile, feature high-cost lineups of subpar funds. Nor is it uncommon for 401(k) plans to omit exposure to key asset classes--I've seen 401(k)s whose only bond exposure comes from government bonds.

To sum up, it makes sense to keep the big picture in mind. As tantalizing as it might seem to get more assets over into the Roth column, contribution limits on IRAs mean that any Roth assets you amass via the backdoor maneuver are apt to be a small piece of your total investment pie. You need to be careful not to degrade the bigger piece--the IRAs that you might roll into a 401(k)--just to put the smaller piece into the Roth category.