Editor’s Note: Steven Jarvis will host “The 2023 Next Level Tax Planning Summit” for advisors on Sept. 27-29 in Las Vegas (virtual option also available).
Tax planning can mean a whole range of things depending on the context. The title of this article might seem to imply tax planning of the “let’s hope no one notices variety,” but to be clear: Everyone should pay every dollar of tax they are legally required to, but that doesn’t mean you have to leave a tip.
While the tax code is full of complexities (also read “opportunities”), very few provide for tax-free income, making Roth accounts a unique and powerful tool. Because of their potential to generate tax-free income, there have always been limitations on how the accounts can be funded and who can participate. Along the way as rules were changed and interpreted, an exception to those limitations was inadvertently created. This happy accident created a path for getting dollars into a Roth even though the direct route to contribution was no longer available. This has come to be known as a backdoor Roth (BDR).
BDRs essentially allow individuals who exceed the Roth IRA limits to make a contribution. For 2023, for example, a married couple filing jointly cannot make a Roth contribution if their adjusted gross income is $228,000 or more. But people who exceed that limit can still make an after-tax contribution to a traditional IRA — and can do a Roth conversion with those funds because the IRS does not have income limits on conversions.
It’s important to note that although this opportunity was created by accident and you will not find BDR referenced anywhere in the tax code, the IRS has acknowledged that the approach is permitted. Congress has discussed changing these rules, but nothing has come to fruition. You can learn a lot more about the strategy at The 2023 Next Level Tax Planning Summit.
While BDRs are permissible, you must jump through hoops to make sure they are implemented correctly. But first, it’s important to understand the potential value of the strategy and whether the tax reporting burden is worth the effort.
A six-figure difference
For a married couple filing jointly, assuming a 37% tax rate and a 7% annual rate of return, the difference in the total net account balance (i.e., the account balance after the IRS takes their share) in 30 years for a Roth vs. a traditional (pre-tax) IRA is more than $500,000. At a 5% return, the difference is closer to $350,000. If the couple’s tax rate is 24% and the portfolio returns 5%, the difference is just under $240,000.
Even applying this strategy over a five-year period has the potential to increase the ending net balance in a taxpayer’s retirement account by $20,000 to $30,000. The 30+ year timeline increases the dollar amounts involved but is not a prerequisite to the strategy having value.
Three additional assumptions are critical to understand:
- These numbers are all based on tax rates being consistent to simplify the math for this article and to illustrate that tax rates would have to drop for there to be a negative outcome. If tax rates go up, the benefit of a Roth is even bigger. The question then is “are you concerned that tax rates might go up in the future?”
- These outcomes are also based on fully funding the retirement account, which for a married couple filing jointly in 2023 would be $7,500 each (assuming each spouse is over age 50), or $15,000. In the 24% tax bracket, that means that it takes nearly $20,000 of income to have enough after-tax money to fund the Roth. The numbers above assume that the tax savings today from contributing to a pre-tax account are nototherwise invested. While the outcome would change somewhat if those dollars were invested in a taxable account, it is rare that taxpayers consistently invest the difference and this article focuses on practicality and reality as opposed to theory and purely mathematical optimization.
- The BDR strategy is being consistent and accurately executed each year.
The third assumption might be most pivotal because of how often in the real world a BDR is well intended but poorly executed. Each year a BDR is completed, there are multiple reporting requirements on the annual tax return — meaning multiple places the process can go wrong. Here are the most common pitfalls and how to avoid them.
A tax impact is reported in the current year
Perhaps the worst form of tipping the IRS is paying taxes on the same income twice. The goal of a BDR is to contribute after-tax dollars to an IRA, skip the current-year tax deduction and then convert the entire amount to a Roth. Two places this can create issues in the current year is if the contribution is incorrectly reported as deductible (line 20 of Schedule 1 to IRS Form 1040) or if the distribution of the after-tax basis is reported as taxable income (line 4b of the IRS Form 1040). The BDR has to be reported, but when done correctly it will result in no increase or decrease to taxable income in the current year. (The situation is more complicated when the IRS pro-rata rule applies or when the after-tax IRA increased or decreased in value before being converted.)
The custodian won’t provide all information to report a BDR correctly
Because a BDR includes a distribution of after-tax dollars from an IRA to then be converted to a Roth, a custodian will issue a Form 1099-R for the year. And since custodians are limited in which information they can include, Form 1099-R will have the dollar amount of the BDR, but no clear indication that those dollars are in fact a BDR. Whether a person prepares their own taxes or works with a professional, a custodian needs to share information beyond that 1099-R for everything to be reported correctly to the IRS. Like any great tax planning, the strategy isn’t complete until all of the reporting is done.
Missing a critical reporting date
For a BDR to be successful, three key steps must be reflected on the tax return: 1) contribution, 2) distribution, 3) conversion. But not all these steps have the same deadline for a given year. Using 2023 as an example, contributions can be made through the initial tax filing deadline for the 2023 tax year, or April 15, 2024. The distribution and conversion (which should happen simultaneously) have to be complete by December 31, 2023, to be reported on the 2023 tax return. If a 2023 contribution is made after December 31, 2023, and before April 15, 2024, the contribution is reported in one tax year (2023) and the distribution and conversion are reported in the next tax year (2024).
Expecting the IRS to track “basis” for you
In tax terms, “basis” is the amount of an IRA that represents after-tax, or nondeductible contributions. It’s critical for the taxpayer to know and report basis prior to a conversion because that is the portion of the account that can be distributed tax free. As long as the after-tax basis is still sitting in a traditional IRA, any growth or earnings will be taxable, creating the need to convert the basis to Roth.
Basis might be intentionally carried from one year to the next (like in the example under the previous section, regarding reporting on dates) but basis is also created accidentally at times. This happens when a taxpayer makes an IRA contribution not realizing they were ineligible to deduct the contribution. In those situations, or when there is a time-lag between contribution and conversion (an issue we see), it is up to the taxpayer to recognize and track the basis or it will be lost to time and the taxpayer will ultimately pay taxes on those dollars twice.
Not filling out IRS Form 8606 correctly
Just as IRAs and Roth IRAs are individual retirement accounts, reporting on BDRs has to be done individually on IRS Form 8606. This is a crucial distinction for couples that are married filing jointly. In any case, Form 8606 is how after-tax contributions to an IRA are reported, along with the subsequent tax-free distribution from the IRA and ultimately the conversion to Roth. Part I of Form 8606 covers the contribution, distribution, and any basis that was carried forward from a prior year or that will be carried forward to a subsequent year. Part II of the form reports the conversion to Roth. Both sections are required to accurately report the movement and treatment of funds throughout the execution of a BDR.
Backdoor Roth contributions can be a powerful way to save for the future while taking advantage of opportunities to pay less in taxes. However, to do this successfully it takes a proactive and intentional plan that creates a framework for accurate reporting and avoiding costly mistakes. The list of pitfalls and requirements may feel daunting, but BDRs are successfully done every year by taxpayers with the right education or working with an educated professional in their corner.
Happy tax planning!
Steven Jarvis, CPA, MBA, is cofounder of Retirement Tax Services, which offers year-round tax services to financial advisors and their clients. Retirement Tax Services will host “The 2023 Next Level Tax Planning Summit” on Sept. 27-29 in Las Vegas (virtual option also available).