Avoiding "Back Door" Roth IRA Tax Pitfalls

Physicians and other high-income professionals are often interested in creating tax-free income in retirement. Many are aware of the “Back Door” Roth IRA and consider it a favorable means to do so.

While it may often be advantageous to implement a “Back Door” Roth IRA, there are sometimes factors that make this a suboptimal strategy from a tax perspective.

This article highlights the importance of understanding your situation before executing a “Back Door” Roth IRA so that you do not create tax consequences you would otherwise have hoped to avoid.

Why the “Back Door” Roth IRA exists.

In 2019, taxpayers married filing jointly may not directly contribute to a Roth IRA when their modified adjusted gross income is above $203,000. A corresponding income limit for direct Roth IRA contributions is also applied to single filers. There is no income limit, however, prohibiting converting pre-tax traditional IRA contributions to a Roth IRA after the fact. Rolling over nondeductible traditional IRA contributions to a Roth IRA is also allowed.

Thus the “Back Door” Roth IRA exists.

The lack of any rule barring high income earners from implementing this transfer from the traditional IRA to the Roth IRA is what gives the “Back Door” Roth IRA relevance. So while in practice you cannot contribute directly to a Roth IRA if your modified adjusted gross income is above $203,000 as a taxpayer married filing jointly, you can make a nondeductible contribution to a traditional IRA and subsequently roll that amount over to a Roth IRA. 

As will be seen later on, to effectively execute this strategy, it is important that by December 31st of the tax year you implement a “Back Door” Roth IRA all traditional IRA account balances be $0. Remember, the amount contributed to a Roth IRA is nondeductible: you include it in your gross income for the tax year, but the amount grows tax free, and distributions may be tax free as well.

The Pro-Rata or “Cream-in-the-Coffee” rule.

The Internal Revenue Code (I.R.C.) treats all traditional IRA plans (IRA, SEP-IRA, and SIMPLE IRAs) as one plan, and all distributions during any taxable year as one distribution. This complicates planing if you have multiple traditional IRA balances and want to execute a “Back Door” strategy. As shall be seen, this rule determines the proportion of pre, or post-tax money going into a “Back Door” Roth IRA. 

Under  I.R.C. § 408(d)(1) distributions from IRAs are included in gross income. I.R.C. § 72(e)(8)(B), outlines that retirement plan distributions are proportionate to the amount of pre and post-tax money in the plan. While I.R.C. § 408(d)(3)(A) outlines that rollovers are generally nontaxable, for rollovers from a traditional IRA to a Roth IRA, however, “there shall be included in gross income any amount which would be includible were it not part of a qualified rollover contribution” [I.R.C. § 408A(d)(3)(A)].

Because all traditional IRA accounts (IRA, SEP IRA, and SIMPLE IRA) are considered one account, and rollovers from traditional plans to Roth plans carry a proportional amount of total pre and post-tax funds across all accounts, taxable income will be recognized based on pre-tax contributions in the traditional IRAs and be taxed when attempting a “Back Door” Roth IRA based on the balance in the account as of December 31st of the tax year of execution. For this reason, it is important to have an aggregate $0 traditional IRA balance by the end of the year if you hope to effectively execute a “Back Door” Roth IRA.

The pro-rata rule is also commonly known as the “Cream-in-the-Coffee” rule. Once cream has been mixed with coffee (or pre-tax and post-tax IRA contributions have been made to traditional IRAs), every sip (distribution) contains a little bit of cream and a little bit of coffee. The amount being rolled over through a “Back Door” Roth IRA contains the proportional amount of pre and post-tax dollars according to their overall proportion across all traditional IRA accounts.

For this reason, it may be undesirable for taxpayers in high tax brackets to attempt a “Back Door” Roth IRA if they are not able to get their traditional IRA balance down to $0 in the tax year of execution. A better strategy would be to distribute or convert the money when the taxpayer is in a lower tax bracket.

Strategies to avoid the “Cream-in-the-Coffee” tax pitfall.

There are ways to bring traditional IRA balances down to $0 so that a “Back Door” Roth strategy can be implemented effectively. Depending on your situation, these strategies may include:

  • Roll traditional IRAs into a 401(k) plan (if the plan allows it);

  • Take traditional IRA amounts out as distributions; or 

  • Convert the traditional IRA amounts to a Roth IRA. 

If your IRA balance is low, it may be reasonable to convert the entire amount to a Roth IRA, thereby arriving at a $0 balance across traditional IRAs. Additionally, if you’re over age 59 ½, you might consider distributing IRA funds so that your balance is $0 across traditional IRA accounts. Depending on your circumstances this may not be desirable at all, however, especially if your traditional IRA balance is high, you find yourself in a high tax bracket, or you actually need to keep the money invested to have a successful retirement!

For physicians and other high income professionals in a high tax bracket and with high pre-tax IRA account balances, it is unlikely to be desirable to convert your entire traditional IRA accounts to a Roth IRA. This would necessitate converting pre-tax dollars at a high tax rate. 

For the high income professional with a high pre-tax IRA account balance, it is worth looking into whether your 401(k) provider will allow you to roll your traditional IRA into your 401(k) plan. If this can be accomplished, you may be able to execute a “Back Door” Roth IRA in the future without worrying about the pro-rata, or cream-in-the-coffee rule [because there will no longer be a traditional IRA with a balance—it will have been rolled into the 401(k) plan].

If this is not possible, an additional strategy worth considering is to execute Roth conversions when you are in a lower tax bracket (perhaps during years in which you are working part-time, or are retired).

Some final thoughts.

The “Back Door” Roth IRA is a strategy worth looking into in order to create tax-free retirement income. But remember that the unique circumstances of your situation may necessitate adjustments before employing this strategy, or a complete abandonment of it entirely.


Disclaimer:

The content you just read is for informational purposes only. Yes, I’m a financial advisor, but this article really isn’t intended as advice for you specifically. Your unique situation needs to be taken into account, and the ideas presented here may not apply. 

So, please make sure you do your due diligence BEFORE implementing anything. Due diligence includes hiring a qualified professional who understands your situation completely and can offer you personalized advice.


Donovan Sanchez