Backdoor Roths aren't just for IRAs

And how the Tax Cuts and Jobs Act affects this strategy

Joe Brummel | May 2018 Footnote

You've heard it before: It's not just what you make, but what you keep that matters. That's especially true when it comes to planning for retirement income.

For many individuals, this means saving as much as possible in tax-deferred or tax-free accounts. However, as income increases, the ability to make deductible contributions and/or direct Roth contributions evaporates, but that doesn't mean your ability to use a Roth account does. Thanks to provisions in tax law, there is an indirect -- or backdoor -- method that can be used regardless of income. It is my hope you take from this article options to consider for your own retirement as well as those whom you may advise.

What is the backdoor Roth IRA strategy?

The backdoor Roth IRA strategy consists of two separate transactions: a nondeductible contribution to a traditional IRA and a Roth IRA conversion. When the conversion occurs, this nondeductible "basis" is applied against the converted amount and taxes are paid on any increase from the time of the contribution. Once the funds are inside the Roth IRA, all future appreciation may avoid taxation and so will all qualified distributions. This strategy is only available to people with earned income, and it is only relevant for those who make too much to qualify for a deductible traditional IRA or direct Roth IRA contribution.

While professional debate has ensued regarding the execution and viability of this strategy, the 2017 Tax Cuts and Jobs Act Conference Committee Report provides clarity that Congress intends to allow it. The report reads, "Although an individual with AGI exceeding certain limits is not permitted to make a contribution directly to a Roth IRA, the individual can make a contribution to a traditional IRA and convert the traditional IRA to a Roth IRA."

It's all about that basis

It's important to understand that nondeductible "basis" is applied to conversions (and any distributions) pro-rata to the total value of all other pre-tax IRA assets (including traditional, SEP and SIMPLE IRAs). Consequently, the backdoor Roth IRA strategy generally is beneficial when the individual doesn't have other IRA assets. Tax would only apply to any earnings between the contribution and conversion dates. If the individual has other IRA assets, the nondeductible "basis" will be allocated pro-rata, relative to the total year-end fair market value of the combined accounts.

For example, if someone has a $5,500 traditional IRA funded with deductible contributions and plans to make a $5,500 nondeductible contribution to the same IRA in the current year, it is not possible to convert $5,500 to a Roth IRA without incurring taxable income on a pro-rata share of the deductible contributions. In this case, a $5,500 Roth conversion would create $2,750 of taxable income because only 50 percent of the nondeductible basis is applied.

Shut the door on the pro-rata rule with employer plans

A creative strategy exists for those who find themselves restricted by a large tax-deferred IRA balance, and who are employed with an active 401(k), 403(b) or 457(b) plan allowing IRA roll-ins. These individuals may be able to roll their pre-tax IRA accounts back into the employer plan, which removes these accounts from the pro-rata conversion calculation.

Another backdoor with employer plans

There is also a backdoor option for employer plans that can provide a larger opportunity to indirectly contribute funds into Roth 401(k) and 403(b) accounts, regardless of income. Unfortunately, this backdoor Roth strategy is not possible with 457(b) plans, as they cannot receive after-tax contributions.  

So, how does this work in a 401(k) or 403(b) plan?

Much like the backdoor IRA strategy, it involves a nondeductible after-tax contribution and a Roth conversion. The key differentiation for employer plans is the treatment of the nondeductible amounts at the time of conversion. For employer plans, the pro-rata rule doesn't apply, and the after-tax contributions can directly apply to the conversion. While that can be a significant benefit compared to IRAs, most plan participants will find their employers currently do not offer after-tax contributions with in-plan Roth conversions.

For plans offering those options, and if they allow after-tax Roth conversions to be distributed at any time, additional financial planning opportunities are available. No tax penalties apply on the distribution of converted amounts if the Roth account has been open for at least five years. This opens efficient planning opportunities, such as saving for a child's college because Roth money is not part of the FAFSA financial aid consideration (529 plans are), and any money not used for college could remain in the account for the owner.

How can employers take advantage of these provisions?

These employer plan strategies are sophisticated arrangements with which few advisers or administrators are proficient and experienced. Many factors need to be considered, including contribution limits, nondiscrimination testing and record-keeping capabilities. Once set up, this arrangement should be reviewed annually and adjusted as needed. Even if the administrative feasibility exists, adequately communicating this offering to employees can be challenging.  

Unless saving for nonretirement goals, an employee would want to maximize their pre-tax and direct Roth contributions before taking advantage of a backdoor Roth. How much an employee can contribute after-tax will depend on whether they are deemed highly compensated or not. With all plan contributions considered, the maximum for 2018 is $55,000, plus another $6,000 if turning 50 or older for catch-up contributions.

For example, let's assume an employee, younger than 50, contributed the pre-tax maximum of $18,500, and receives $3,000 in match and $4,000 in profit sharing from his or her employer. With a total plan contribution limit of $55,000, that leaves $29,500 in capacity for a potential backdoor Roth strategy. That is a substantial amount, but it could be less based on the individual's compensation (you cannot contribute more than you make) and his or her plan's contribution limit percentage. This is not an arrangement you set and forget about; these numbers can shift from one year to the next.

From the employee's perspective, no earned income limits apply. However, highly compensated employees may be limited or potentially unable to take advantage of the backdoor Roth strategy. The key consideration is the plan's ability to pass nondiscrimination testing. Safe Harbor plans, which essentially provide a free pass on some key nondiscrimination tests, aren't fully exempt from this requirement. After-tax contributions are still subject to testing, and they are added to any company matching contributions for the Average Contributions Percentage (ACP) test. That is one of the most critical aspects of an administratively feasible backdoor Roth 401(k) or 403(b).

What should plan participants consider?

With the 2017 Tax Act, the ability to recharacterize a Roth for any reason was repealed, so it's important to be absolutely sure of all implications before converting any money to a Roth. It's also extremely important that conversion request forms are completed properly -- there is no going back once the paperwork is filed. These forms can be complicated and confusing, and mistakes can lead to unintended and significant tax implications.

Moving forward

To keep more of what you make, you must take advantage of every tax planning opportunity available. For some individuals, backdoor Roth strategies through an IRA and/or employer plan have the potential to make your money go farther.

The Roth IRA offers tax deferral on any earnings in the account. Withdrawals from the account may be tax free, so long as they are considered qualified. Limitations and restrictions may apply. Withdrawals prior to 59 ½ or prior to the account being opened for five years, whichever is later, may result in a 10-percent IRS penalty tax. Future tax laws can change at any time and may impact the benefits of Roth IRAs.

Traditional IRA account owners should consider the tax ramifications, age and income restrictions regarding executing a conversion from a Traditional IRA to a Roth IRA.

Joe Brummel is director of retirement plan consulting for Wealth Enhancement Group. He and his team are advocates for helping plan sponsors build comprehensive retirement plans and preparing workers for retirement. You may reach him at or 952-249-4902.

This information was developed as a general guide to educate plan sponsors but is not intended as authoritative guidance or tax or legal advice. Each plan has unique requirements, and you should consult your attorney or tax adviser for guidance on your specific situation. In no way does the author assure that, by using the information provided, the plan sponsor will be in compliance with ERISA regulations.

Securities offered through LPL Financial, Member FINRA/SIPC. Investment advice offered through Wealth Enhancement Advisory Services, LLC, a registered investment adviser. Wealth Enhancement Advisory Services, LLC and Wealth Enhancement Group, LLC are separate entities from LPL Financial.