How to Use the ‘Backdoor’ Strategy to Contribute to a Roth IRA

The Tax Cuts and Jobs Act of 2017 (TCJA) resulted in a temporary reduction in marginal tax rates for individuals. However, the TCJA made few changes to retirement plans.

Federal employees are still eligible to contribute the maximum IRS elective deferral amount each year (during 2023, $22,500) to the Thrift Savings Plan (TSP). Those employees over age 49 during 2023 can contribute an extra $7,500 in “catch-up” contributions to the TSP. All employees are also eligible to contribute $6,500 ($7,500 if over age 49 during 2023) to some type of Individual Retirement Arrangement (IRA) for 2023.

There are two types of IRAs – traditional and Roth. Unlike traditional IRAs, Roth IRAs have income limits for contributing. The result is that many high earning federal employees are ineligible to contribute to Roth IRAs. For 2023, married individuals cannot make a Roth IRA contribution if their modified adjusted gross income (MAGI) exceeds $228,000. Single individuals cannot contribute to a Roth IRA during 2023 if their MAGI exceeds $153,000.

In the past – and still true under TCJA – high income individuals have used the “backdoor” Roth IRA strategy to move funds into their Roth IRAs. This column discusses how the backdoor Roth IRA strategy works and how it can benefit high income federal employees.

In short, the backdoor Roth IRA strategy allows individuals to move funds into a Roth IRA even if they do not qualify to contribute to a Roth IRA because their income exceeds the allowable limits. To do so, these individuals, or if they are married their spouses, must have earned income (salary, wages or net self-employment income).

No matter the amount of their annual income, they are eligible to contribute to a nondeductible traditional IRA – as much as $6,000 ($7,000 if over age 49) during 2022 (the deadline to make an IRA contribution for 2022 is April 18, 2023) – and then immediately convert that contribution to a Roth IRA. This is the case no matter their age, income or tax filing status. Congress and the IRS have said that the backdoor Roth strategy is a perfectly legal strategy, and many high income individuals have successfully used the strategy over the years.

However, there had been talk in recent years that Congress would get rid of this Roth IRA loophole. But elimination of the loophole was not specifically part of the TCJA or the SECURE Act 1.0 passed into law in December 2019 and SECURE 2.0 passed into law in December 2022.

Here is one of several references from the US House of Representatives conference report confirming continued use of the backdoor Roth strategy: “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.”

5 Advisories for the Backdoor Roth IRA Strategy

The following five advisories are for individuals who intend to convert a nondeductible traditional IRA that they contributed to for the year 2022 to a Roth IRA during 2023 via the backdoor strategy:

1. Individuals and/or if married, their spouses, must have had earned income during 2022.

For married couples, each spouse can perform a “back door” Roth IRA conversion. The maximum that can be contributed to a traditional IRA for 2022 is $6,000 for individuals younger than 50, or $7,000 for individuals who were over age 49 as of December 31, 2022.

2. Individuals have until April 18,2023 to make their 2022 traditional IRA contributions and file IRS Form 8606 (Nondeductible IRAs) with their 2022 federal income tax returns.

If they have already filed their 2022 federal income tax return, they can file the 2022 Form 8606 by itself, reporting the 2022 traditional IRA contribution.

3. The backdoor Roth IRA conversion strategy works no matter the age of the individual, even if the individual has reached the age for taking traditional IRA required minimum distributions (RMDs)

4. The backdoor rule applies to a Roth IRA conversion.

This means that all owned traditional IRAs, including SEP IRAs and SIMPLE IRAs, are included in the pro-rata calculations in order to determine how much of the traditional IRA funds will be taxable upon conversions. What this implies is that some of the conversion may be taxable. Federal employees with pre-taxed traditional IRAs and TSP accounts can avoid paying taxes on the conversion by first transferring any pre-tax traditional IRAs into their traditional TSP accounts. They may do so by going online to www.tsp.gov and requesting a transfer of traditional IRAs into their traditional TSP).

Note that the pro-rata traditional IRA calculation operates as follows:

Tax-free portion of converted traditional IRA funds equals:
Amount of converted IRA funds times (after-taxed IRA balance) / (total IRA account balance)

Taxable portion of converted traditional IRA funds equals:
Amount of converted IRA funds times (before-taxed IRA account balance) / (total IRA account balance)

The following example illustrates:

Jan is a single federal employee whose modified adjusted gross income (MAGI) during 2022 was $200,000, far above the $144,000 MAGI limit for contributing to a Roth IRA. Jan instead contributes $6,000 to her traditional IRA. Because Jan is covered by a pension plan (FERS) and because Jan contributes to the TSP, Jan’s $6,000 contribution to her traditional IRA is nondeductible. Jan will file IRS Form 8606 (Nondeductible IRAs) with her 2022 federal income tax return reporting the $6,000 traditional IRA contribution. In so doing, Jan is notifying the IRS that the $6.000 IRA contribution was already-taxed money and will be withdrawn from the IRA tax-free.

Jan actually has three IRAs. One IRA is a rollover IRA from a previous employer’s 401(k) plan that is currently worth $50,000. Jan also has a SEP-IRA (also from a previous employer) that is worth $40,000, and she has a $10,000 traditional IRA that consists entirely of after-taxed contributions of $10,000 and no earnings.

Under the pro-rata rule, Jan’s IRA account has a balance of $100,000 ($50,000 plus $40,000 plus $10,000). Of the $100,000, $10,000 is already taxed funds. The other $90,000 is money that has never been taxed. This means that if Jan were to convert the $6,000 traditional IRA contribution to a Roth IRA, only 10 percent of the conversion will be tax-free. The 90 percent of the conversion will be taxable, as shown here:

Tax-free portion: $6,000 times $10,000/$100,000 equals $600.

Taxable portion: $6,000 times $90,000/$100,000 equals $5,400.

Note that Jan is paying tax on 90 percent of her converted IRA funds even though the $6,000 was previously taxed before it was contributed to the traditional IRA. To avoid paying tax again on 90 percent of her converted IRA funds (in Jan’s case, the $6,000), Jan should have first transferred her $50,000 pre-taxed traditional IRA and her $40,000 SEP IRA into her TSP account. If she had done that, then her IRA account would have a total balance of $10,000 consisting of already-taxed funds. In that case, 100 percent of the conversion will be tax-free, as shown here:

Tax-free portion: $6,000 times $10,000/$10,000 equals $6,000.

Taxable portion: $6,000 times $0/$10,000 equals $0.

5. The funds that end up in the Roth IRA via a “back-door” conversions are considered converted funds and not Roth IRA contributions.

As such, individuals under age 59.5 who perform a backdoor conversion must wait five years for penalty-free access to those funds. On the other hand, if the funds went in as Roth IRA contributions, the contributions would be accessible immediately, tax- and penalty-free.