What’s the hands-down easiest way for the 99% to build wealth? Answer: index investing in tax-advantaged retirement accounts like IRAs and 401ks. The more you can contribute into your retirement accounts, the better. The benefits are truly astounding – way beyond just saving for retirement. I am always looking for new ways I can maximize my contributions into these accounts. The “Backdoor Roth“ and the “MEGA Backdoor Roth” are two tax loopholes that allow savers to bypass annual contribution limits for Roth IRAs. But if you’re not careful, you can be hit with a big tax bill when you do it. Here’s how to avoid taxes on a Backdoor Roth Rollover.
The Backdoor Roth moves non-deductible after-tax money through a regular IRA account into a Roth IRA, while the MEGA Backdoor Roth moves it through a 401k account into a Roth IRA. Read about the details of how the Backdoor Roth works and who can do it here.
The final step in the Backdoor Roth process is the “rollover”. This is when you convert funds from the Regular IRA (in the case of a Backdoor Roth) or from your 401k (in the case of a MEGA Backdoor Roth), into your Roth IRA.
The Pro-Rating Trap
The problem about the Backdoor Roth rollover is that it must be pro-rated, to the extent you have made any pre-tax contributions into your IRA. This is a problem, because most people have pre-tax contributions in their IRA.
For example, let’s say you want to backdoor $5,000 into your Roth. But, say you also already have $10,000 in your regular IRA, consisting of pre-tax contributions. Your first step is to contribute the $5,000 of after-tax money into your regular IRA. Once you do that, then 1/3 of the regular IRA account would be after-tax and 2/3 is pre-tax.
Now, let’s say you complete your Backdoor Roth by rolling over $5,000 into your Roth. Unfortunately, in this case you cannot only rollover the after-tax funds. Rather, 2/3 of your rollover will pre-tax, and only 1/3 will be after-tax. The problem is that sending pre-tax money into a Roth IRA generates taxable income. That means you’ll have to pay taxes on 2/3 of your rollover. Son, you’ve just added $3,333 of taxable income (2/3 of $5,000) thanks to your Backdoor Roth. Please don’t do that.
Avoid Taxes With Multiple Destinations
The good news is that there is another path. Even though you must pro-rate your Backdoor Roth rollover, you are allowed to use multiple account destinations, and you can designate which funds go to which destination. You can send the after-tax money to your Roth IRA, and the pre-tax money to a different regular IRA, or to any other pre-tax account that accepts rollovers. (see this handy chart for other acceptable destinations)
So, continuing the above example, your rollover would still consist of 2/3 pre-tax money ($3,333) and 1/3 after-tax money ($1.667) – but you can send the $1,667 of after-tax money specifically to a Roth IRA, while you send the $3,333 of pre-tax money to a different destination – such as another regular IRA account.
In this way, the rollover can be entirely tax-free. Both the $3,333 of pre-tax money and the $1,667 of after-tax money qualify as a tax-free conversion if sent to the correct destination.
Congratulations, you have just back-doored $1,667 into a Roth IRA, tax free.
Maintain Two Regular IRA Accounts
To take advantage of the multiple destinations rule, you need to maintain two separate regular IRA accounts. It can even be two accounts at the same custodian (e.g. Vanguard) – as long as they are separate accounts. You’re only allowed one rollover per year, so each year that you do a Backdoor Roth, you would move your regular IRA funds between your two accounts.
“Let It All Roll”
But, Houston, we have a problem. Continuing with our above example, after rolling over the $5,000, you still have $10,000 left over in your original IRA account. You also sent $3,333 to a second regular IRA account, so now you have a total of $13,333 of funds in regular IRAs.
Of this, $3,333 is now after-tax money (25% of $13,333), and 10,000 is now pre-tax money (75%). If you do a new Backdoor Roth each year, you can quickly lose track of these numbers, unless you are super organized with your contribution history. This is why partial rollovers are no good. It’s much easier to just let it all roll.
If you rollover ALL of your funds each year you do a Backdoor Roth (still pro-rated between a Roth and regular IRA), then 100% of your regular IRA funds would stay pre-tax. This is much simpler to track. It just requires you to maintain two regular IRA accounts, and each year you backdoor your Roth, you just transfer the pre-tax funds from one IRA account to the other. If you keep the two accounts at the same custodian, you don’t even have to change your investments.
Read all about after-tax rollover rules here, including the lovely multiple destination rule.
Check out this handy chart about other possible rollover destinations.