Ideally, I want this guide to clarify and explain three important things:
1. The technical jargon you’ll run into as you navigate a backdoor Roth contribution.
2. Why you may need or want to do a backdoor Roth contribution.
a. Including the mega and sidedoor varieties.
3. And, of course, how to actually do it!
Here are the terms you’ll come across as you navigate a backdoor Roth contribution (including one I just made up for fun), what they mean, and why they matter. To clear up the biggest technical detail: “Backdoor Roth contributions” are actually non-deductible contributions to a traditional IRA or employer-sponsored plan that you subsequently convert to a Roth balance.
When you finish this section, you’ll actually know what that means, I promise. 🙂
Annual Additions Limit — For an employer-sponsored plan account specifically, the annual additions limit is the total amount that you can add to a plan account during a tax year. Funds added to an account include elective salary deferrals — pre-tax and/or deemed Roth — employer matching contributions, profit-sharing contributions, and voluntary after-tax contributions. The annual additions limit is $58,000 (plus $6,500 if the participant is 50 or older at the end of the tax year) in 2021. If your plan allows for voluntary after-tax contributions and in-plan Roth conversions or in-service distributions, you may be able to fund a mega-backdoor Roth contribution.
Conversion — Technically, this is a rollover of pre-tax, voluntary after-tax, or non-deductible (aka after-tax) money to Roth money. It can occur on a trustee-to-trustee basis (even at the same trustee), from an employer-sponsored plan to an IRA, or even indirectly between IRAs. A conversion is the thing that makes a backdoor Roth contribution happen.
Deductible/Pre-Tax Contributions — Whether made to your employer-sponsored plan account or your traditional IRA, you did not pay taxes on the money used to make these contributions. If you have balances in your traditional IRA that include deductible/pre-tax contributions, you won’t be able to make a backdoor Roth IRA contribution.
Elective Deferral Limit — This is the amount of money you can contribute to an employer-sponsored plan account on a pre-tax or deemed Roth basis. In 2021, this limit is $19,500. Plan participants age 50 or older at the end of the tax year can contribute an additional $6,500. For some employer-sponsored plans, this is the tip of the contribution iceberg. Find out if you can make voluntary after-tax contributions in your plan’s Summary Plan Description.
Form 8606 — This is the tax form used to report nearly all aspects of your backdoor Roth IRA contributions. If you’ve ever even considered making a backdoor Roth IRA contribution, you should get really familiar with Form 8606. There’s a good chance that you’ll be using this form to report either your backdoor Roth contributions or your non-deductible traditional IRA balances — or both.
In-Plan Roth Conversion — Not available in all plans, this is the ability to convert pre-tax or voluntary after-tax contributions into deemed Roth balances within an employer-sponsored plan account. It’s a potential prerequisite to the mega-backdoor Roth contribution strategy.
In-Service Distribution — An alternative to the in-plan Roth conversion, in-service distributions allow participants to roll over funds from their employer-sponsored plan accounts to their traditional and/or Roth IRAs while still working for their employers. If your plan doesn’t offer in-plan Roth conversions but it does allow in-service distributions of voluntary after-tax contributions, you may still be able to execute a mega-backdoor Roth contribution.
Mega-Backdoor Roth — This specific flavor of backdoor Roth contributions involves the immediate conversion of voluntary after-tax contributions made to an employer-sponsored plan account into the deemed Roth balance within the plan. Because voluntary after-tax contributions are subject to annual additions limits and not elective deferral limits, some may find they have the ability to contribute tens of thousands of dollars to their Roth balances this way.
Non-Deductible/Voluntary After-Tax Contributions — This is money in your traditional IRA or employer-sponsored plan account (not including Roth balances) that you did pay taxes on when you made the contribution(s). Growth on these balances is considered to be pre-tax, which means that it will be taxable when distributed. Backdoor Roth “contributions” start as non-deductible/voluntary after-tax contributions that you later convert to a Roth IRA or Roth balances in an employer-sponsored plan account.
Qualified Employer-Sponsored Plan (Account) — Think 401(k). These are qualified retirement plans that employers sponsor. While SIMPLE and SEP IRAs are indeed employer-sponsored, they function more like IRAs — because they are literally IRAs — than qualified employer-sponsored plan accounts like 401(k)s. When you see “employer-sponsored plan account” in this guide, think of relevant non-IRA account types like the 401(k).
Rollover — And the little one said that this is the movement of funds between employer-sponsored plan accounts and IRAs. Direct rollovers occur when the taxpayer never takes possession of the funds (i.e., never receives and deposits a check made payable directly to the taxpayer). Backdoor Roth IRA contributions may require a direct rollover from a traditional IRA to an employer-sponsored plan account. Mega-backdoor Roth contributions may require a rollover from the employer-sponsored plan account to a Roth IRA and sometimes a traditional IRA as well.
Roth (Balances) — Whether a Roth IRA or a deemed Roth amount within an employer-sponsored plan, Roth balances are specific after-tax contributions that are also growing tax-free. If taxpayers meet certain rules, they can distribute these amounts completely tax-free as well. This is, of course, the end goal and the reason why any of the hoops are worth jumping through.
Sidedoor Roth — This is my own label for the conversion of a SIMPLE or SEP IRA into a Roth IRA. Both have their own caveats, but these may be the last remaining (sort-of) backdoor Roth contribution opportunities if the Build Back Better Act includes the prohibition on converting after-tax balances to Roth. A workaround to the lack of actual Roth contribution options in these plans, a sidedoor Roth contribution involves intentionally including otherwise deductible/pre-tax SIMPLE and SEP IRA contributions in taxable income by converting some or all of the account to a Roth IRA.
SEP IRA or SIMPLE IRA — Two types of small-business retirement plans, these are technically traditional IRAs that are able to receive employer contributions. You have some degree of optionality in how you treat the dollars you contribute to either of these plans through the Roth conversion process. In a sense, the idea that there is no Roth SEP and/or Roth SIMPLE IRA is literally true … but also incomplete. You can fairly easily make any contribution to either account as a part of your Roth IRA balance.
Summary Plan Description — This document spells out the terms and conditions of an employer-sponsored plan. You’ll find details about the contribution types that the plan allows as well as whether you can process in-plan conversions and/or in-service distributions.
Traditional IRA — In this type of IRA, a taxpayer typically keeps pre-tax contributions, but it can also receive after-tax contributions. A traditional IRA is an integral part of the backdoor Roth IRA contribution process. You’ll make both the original after-tax contribution that starts your backdoor Roth IRA contribution to your traditional IRA and you’ll also need to ensure that your traditional — and/or SEP and SIMPLE — IRA is empty on or before December 31 in the year you complete the conversion of the after-tax contribution.
Voluntary After-Tax Contributions — You make this specific type of contribution to an employer-sponsored plan account. It’s permitted by plan design and requisite plan-compliance requirements. As the name suggests, the contribution is both entirely voluntary and made with after-tax/non-deductible money. If left to grow, the earnings are pre-tax funds and taxable at distribution. Converting these contributions to Roth balances as quickly as possible — affording future tax-free growth — is the centerpiece of the mega-backdoor Roth strategy.
WHY WOULD YOU MAKE A BACKDOOR ROTH CONTRIBUTION?
Roth funds have several unique benefits that make them desirable in both the short and long term. To recap:
• Tax-free growth and distributions if you meet certain conditions
• No required minimum distributions (RMDs) during taxpayer’s lifetime
◦ This could also change with the Build Back Better Act for certain high-income taxpayers.
• Ability to distribute contributions/after-tax conversions at any age tax- and penalty-free if certain conditions are met
However, if your “modified” adjusted gross income exceeds certain amounts, you are not able to contribute directly to a Roth IRA and you will need to make a backdoor Roth IRA contribution.
WHO MUST MAKE BACKDOOR ROTH IRA CONTRIBUTIONS?
1. Taxpayers whose adjusted gross income exceeds certain phaseout ranges:
a. Single/Head of Household: $125,000 – $140,000 (2021)
b. Married Filing Jointly: $198,000 – $208,000 (2021)
c. Married Filing Separately: $0 – $10,000 (2021)
i. Note that in almost all cases, taxpayers who are married filing separately will need to make a backdoor Roth IRA contribution because of the low phaseout range.
On the other hand, almost all participants can make Roth contributions to their employer-sponsored plan accounts if their plans permit Roth contributions. This does not mean, however, that all participants in an employer-sponsored plan are able to make mega-backdoor Roth contributions to a plan. To do that, the plan needs a couple of specific features.
WHO CAN MAKE MEGA-BACKDOOR ROTH CONTRIBUTIONS?
1. A participant whose qualified employer-sponsored plan contains both of the following provisions:
a. Voluntary after-tax contributions
b. One of the following:
i. In-plan Roth conversions
ii. In-service distributions
Then, of course, there are participants in small-business retirement plans like SEP or SIMPLE IRAs. They have a workaround for the lack of a true Roth option in these types of plans.
WHO CAN MAKE SIDEDOOR ROTH CONTRIBUTIONS?
1. Participants in SEP or SIMPLE IRA plans.
a. The latter will need to have been first funded at least two years prior to the first conversion.
FIVE STEPS TO MAKE A BACKDOOR ROTH IRA CONTRIBUTION
Prerequisites: No pre-tax money in your traditional, SEP, or SIMPLE IRA or you are a participant in an employer-sponsored plan that accepts rollovers.
1. Determine if you need to make a backdoor Roth IRA contribution. If your income is below the applicable phaseout ranges for your filing status, you do not need to use this strategy.
2. Make a contribution to a traditional IRA at a brokerage that permits Roth IRA conversions (all major brokerages do).
a. You can make this contribution for a specific tax year, up until April 15 of the following year.
3. Convert the amount of your contribution in step 2 to your Roth IRA and invest as appropriate.
a. You can convert a prior year contribution made on or before April 15 at any time during the current tax year without any adverse consequence to the strategy.
b. If your contribution in step 2 grows before you convert it, then the growth portion will be taxed as ordinary income, like a conversion of pre-tax funds.
4. Ensure that your traditional, SEP, and/or SIMPLE IRA are empty ($0.00 balance) on or before December 31 of the year you do the conversion by performing a rollover to an employer-sponsored plan account.
a. This is a critical step if you have any pre-tax IRA balances. If you skip this step, then the conversion will be prorated between your pre-tax and after-tax balances as of December 31 and a majority of your conversion in step 3 will be taxable.
5. File Form 8606 with your tax return to report the transaction.
a. You will make your traditional IRA contribution from step 2 non-deductible on line 1 of the form.
b. You will receive a 1099 reporting the conversion from traditional to Roth IRA with code 2 listed in box 7. This means that the transaction is “taxable” but excepted from penalty.
c. When completing the form, your nondeductible contribution reported on line 1 and distribution reported on line 16 will offset, making your taxable conversion $0.
i. This assumes that the value on line 6 is $0 because you didn’t skip step 4 if it applied to you.
TWO (OR THREE) STEPS TO MAKE A MEGA-BACKDOOR ROTH CONTRIBUTION
Prerequisites: Participation in an employer-sponsored plan that permits voluntary after-tax contributions and in-plan Roth conversions or in-service distributions.
1. Elect to make voluntary after-tax contributions to your employer-sponsored plan account up to the annual additions limits ($58,000/$64,500 in 2021).
a. Your plan’s Summary Plan Description will disclose if your plan permits this type of contribution.
2. Depending on plan rules, convert by either:
a. Requesting to immediately convert your voluntary after-tax contributions to your deemed Roth balance.
i. Read the plan’s Summary Plan Description for details.
ii. The ideal scenario is a plan that immediately converts your after-tax contributions to Roth balance. Some plans have an automated service to do this.
iii. If immediate in-plan conversion is not available, any earnings on the voluntary after-tax contributions (occurring after the contribution but before the conversion) will be taxable when later converted.
b. Requesting an in-service distribution of voluntary after-tax contributions.
i. Read the plan’s Summary Plan Description for details.
ii. Because it’s unlikely that your plan will have a mechanism to immediately distribute after-tax balances, you may end up with some pre-tax growth as a part of the distribution.
3. (If necessary,) Roll over any in-service distributions to your Roth IRA and traditional IRA when needed.
a. The voluntary after-tax contributions go to the Roth IRA, and the growth goes to the traditional IRA.
b. Note that if you also make regular backdoor Roth IRA contributions, you will want to roll the traditional IRA back over to your pre-tax employer-sponsored plan account.
THREE STEPS TO MAKE A SIDEDOOR ROTH CONTRIBUTION
Prerequisites: Participation in an employer-sponsored (including self-employed) SEP IRA or SIMPLE IRA. You must have funded your SIMPLE IRA at least two years prior to your first conversion.
1. Make contributions to your SIMPLE IRA, or let your employer make contributions to your SEP IRA.
a. These contributions will be reported as pre-tax contributions.
2. Convert the amount of your contribution in step 1 to your Roth IRA.
a. This effectively is an election to make the contributions made in step 1 taxable to you in the year earned through reporting the conversion in step 3.
3. File Form 8606 with your tax return to report the transaction.
a. Since you “elected” to make non-taxable money taxable to you, you don’t need to be concerned with emptying out your traditional IRA balances on or before December 31.
b. You will receive a Form 1099 reporting the conversion from traditional to Roth IRA with code 2 listed in box 7. This means that the transaction is “taxable” but excepted from penalty.
c. When completing the form, you will have a taxable conversion amount on line 18 equal to your contributions to the SEP or SIMPLE IRA. This is no different than had you contributed to a Roth IRA directly, except for the fact that you can possibly contribute quite a bit more.
You, dear reader, are now an informed backdoor Roth transactor. Use your new knowledge quickly and efficiently.