Rules and Regulations

Avoid Rushing through the ‘Backdoor’

By Tom Foster

Tax reform has re-ignited interest in a tax-reduction strategy for affluent retirement savers who want to limit their tax liability in retirement. But the strategy – known as “backdoor” contributions to a Roth IRA -- bears careful scrutiny and caution by both financial advisors and their clients before moving ahead.

Tax reform reduced individual tax rates but because of Congressional budget rules, those rates sunset or revert back to 2017 rates unless Congress and the president extend them. The prospect of potentially higher rates in the future is prompting increased questions from both advisors and clients as more people to consider making “backdoor” contributions to Roth IRAs in the hopes of reducing their tax obligations when they retire.

Generally, the strategy appeals to retirement savers who earn higher incomes. Individuals who earn $135,000 or more and couples with combined incomes of $200,000 or more are barred from contributing to a Roth IRA. The “backdoor” Roth technique may be a way around this problem -- but should be considered only if the client understands all of the potential tax consequences.

Here’s how it works. Let’s say you have clients with $100,000 in retirement savings that they have already paid taxes on but are worried about tax liabilities on any investment earnings when they are withdrawn, most likely retirement. The couple earns $250,000 a year together so are ineligible to put the money into a Roth.

But there may be a “backdoor” solution. The clients can put their money into a traditional IRA and then convert it into a Roth IRA. They pay taxes on the amount of earnings between when they put the money into the traditional IRA and then converted it to the Roth, which would likely be minimal after a few days or even a few weeks of investment earnings.

But here’s the catch. If the couple owns multiple IRAs with both pre-tax and after-tax dollars, tax rules require the conversion of both the pre-tax and after-tax money on not only the Roth conversion but all of the IRAs. That may boost their taxes significantly.

In this instance, the couple has $500,000 from previous employers’ 401(k) plans that were rolled in two pretax IRAs. The $100,000 in after-tax money cannot be converted from a traditional IRA into a Roth IRA without paying additional taxes.

Under IRS rules, the $100,000 in after-tax contributions must be divided by the total amount of savings in the two pre-tax IRAs of $500,000, which nets 20 percent. That percentage is used to determine the total after-tax conversion that can be made free of taxes, which in this case is $20,000. The remaining $80,000 is subject to tax. Under tax reform, the couple is in the 24 percent tax bracket for 2018 and thus must pay $19,200 in federal taxes.

If not properly informed, the additional tax bill could result in a nasty surprise for your clients. When discussing the possibility of a “backdoor” Roth conversion, advisors must take care to determine what other retirement assets a client may have, whether those assets are invested in one or more IRAs, and, if so, what type of other IRAs the client owns. Most importantly, the tax rules need to be spelled out so the client absolutely understands his or her potential liability. Of course, anytime a client is considering a transaction with a potential tax implication, he or she needs to consult their tax professional.

There are alternatives to the “backdoor” strategy depending upon the client’s situation. The tax issue may be skirted if the clients are able to roll their pre-tax IRA money into their employers’ 401(k) plans. The $100,000 can be deposited into a traditional IRA and then converted tax-free into a Roth IRA. If clients have not already rolled pre-tax IRA money into their 401(k), they should consult their employer to determine if such rollovers are allowed.

For those who can think longer term, there is another alternative: the “mega-backdoor” Roth IRA conversion. Under this scenario, affluent clients can earmark contributions to a 401(k) on an after-tax basis with the intent of rolling the money over into a traditional IRA and then a Roth IRA, if the employer allows it.

First, the client is encouraged to contribute the maximum allowed to his or her 401(k). That’s $18,500 this year plus another $6,000 if he or she is 50 or older. Then, if his or her employer allows, the client may then contribute additional contributions of up to the $55,000. That’s the limit for all 401(k) contributions, including pre-tax and after-tax by the plan participant and the employer’s match, if available. The limit rises to $61,000 for those 50 and older.

When the client reaches age 59-1/2, he or she may roll the pre-tax savings from his or her 401(k) to a traditional IRA without tax consequences. Then, the client can move the after-tax money into a Roth IRA.

For affluent clients concerned about taxes in retirement, going through the “backdoor” to make use of a Roth IRA can be beneficial. However, there may be significant tax consequences depending upon the client’s individual situation and both advisors and their clients need to tread carefully.

Clients should work with a tax professional to determine what may be right for their particular situation. Make sure your clients make informed decisions about taxes on their retirement savings and avoid rushing through the “backdoor.”


E. Thomas Foster Jr. is head of strategic relationships for retirement plans for Massachusetts Mutual Life Insurance Co. (MassMutual).