There’s a point of confusion I see in a few Facebook groups that I’m a part of – the topic of Roth
conversions and how they relate to the buzz phrase that is “Backdoor Roth”. This post is aimed
at clarifying the two terms, as well as a few others you may have heard on this subject.
First, let’s cover some basics. “Roth” simply refers to the tax treatment of a retirement account.
There’s Roth 401(k)’s AND Roth IRAs. A Roth 401(k) (or 403b, etc.) is an employer-sponsored
retirement plan. A Roth IRA is an individual retirement account and typically not associated
with an employer.
All Roth accounts are funded with after-tax contributions and there are no tax implications of
capital gains, interest, or dividends while inside the account. Since contributions are made
after taxes are paid, one can withdraw the contributed amount from a Roth account tax- and
penalty-free at any time. The earnings (capital gains, interest, dividends), however, must meet
2 criteria before they can be withdrawn tax-free: The account owner must be age 59 ½ AND the
Roth account must have be funded at least 5 years ago.
Now, it’s not hard to see why Roth accounts are so attractive. Most of us retire after age 59 ½
and as long as you have a Roth 401(k) or IRA funded at least 5 years prior, there’s lots of
potentially tax-free money to be had. This brings up the topic of Roth conversions.
Roth accounts are relatively new, with Roth IRAs becoming available in 1998, and Roth 401(k)s
coming about in 2006. Pre-tax or Traditional retirement accounts like Traditional IRAs and
401(k)s were available starting in 1974 and 1978 respectively. As a result, the vast majority of
money in retirement accounts today is pre-tax. For a number of reasons, investors may wish to
“convert” some of their pre-tax (traditional) retirement assets to a Roth account.
A Roth conversion simply refers to transferring money or securities from a Traditional
retirement account to a Roth retirement account. If the converted money is pre-tax, then a
Roth conversion is a taxable event and is subject to ordinary income taxes, but no penalty. Even
when a Roth conversion is a taxable event, it can be a viable tax planning and retirement
planning strategy. For example, it would reduce RMDs in later years, which can affect Medicare
premiums and taxability of Social Security payments.
In some cases a Roth conversion is non-taxable. Since Traditional IRAs (and sometimes
traditional 401(k)s) allow for after-tax (nondeductible) contributions just like Roth accounts do,
a conversion of this money to a Roth would not have tax consequences.
Now you may ask, why would anyone put after-tax money into a Traditional IRA, where the
earnings are taxable upon withdrawal, when they could simply contribute to a Roth IRA where
the earnings are tax-free upon withdrawal? The answer is simple – income limitations. Roth
IRAs have income limitations to make contributions directly, where as Traditional IRAs do not
(for nondeductible contributions). This is where the coveted Backdoor Roth comes into play.
“Backdoor” is a reference to a legal loophole that allows high-income earners to bypass the
income restrictions of contributing money to a Roth IRA. The Backdoor Roth strategy consists of
2 steps:
1. Make a nondeductible contribution to a Traditional IRA.
2. Convert the after-tax money to a Roth IRA.
Since 2010, there are no longer any restrictions on who can do a Roth conversion, and thus the
Backdoor Roth IRA was born.
To summarize so far: A Roth conversion is simply transferring money from a Traditional
retirement account to a Roth retirement account. It may or may not be taxable as income,
depending on the tax status of the money in the Traditional account. Backdoor Roth is 2-step
strategy, one of said steps is a Roth conversion.
There is one major hurdle that comes up for many people when attempting to execute the
Backdoor Roth strategy: The Pro Rata Rule. This rule states that when someone has both pre-
tax and after-tax balances in an IRA (or multiple IRAs), any converted amounts are taxed Pro
Rata based on the ratio of pre-tax to after-tax. In other words, you can’t “cherrypick” and only
convert your after-tax funds.
For example, let’s say you have 2 Traditional IRAs: One was a rollover from an old 401(k) and
has a pre-tax balance of $95,000. You just opened a 2nd Traditional IRA because you read a cool
blog post on how to do a Roth conversion, so you make a nondeductible contribution from your
savings account of $5,000 and also open a Roth IRA for receiving your converted funds.
1. $95,000 pre-tax IRA (95% of total Traditional IRA balances)
2. $5,000 after-tax IRA (5% of total Traditional IRA balances)
3. $0 Roth IRA
Everything is going smooth so far. Enter the Pro Rata Rule. If you execute the 2 nd step of the
Roth conversion (Converting the $5000 IRA to the Roth IRA), the IRS treats your $5,000
conversion as 95% pre-tax and 5% after-tax, even though the $5,000 all came from the account
where made the nondeductible contribution. Ouch!
To maximize the effectiveness of the Backdoor Roth IRA, it is best to not have any pre-tax
balances in a Traditional IRA in the same year you plan to do the Roth conversion. One of the
only ways around this is to rollover the pre-tax IRA balance into an employer sponsored 401(k)
through your employer, if allowed by your plan, since 401(k) balances do not count towards the
Pro Rata Rule. This is sometimes called a reverse rollover, since a typical rollover is from 401(k)
to IRA, not the other way around.
Another downside to the Backdoor Roth IRA is the relatively low contribution limits ($6500 for
2023, $7500 if over age 50). This has led high-income earners and super savers to pursue a
Mega Backdoor Roth. The “Mega” refers to the much higher dollar amount that can ultimately
be put into a Roth account, since it involves the use of a 401(k).
The annual deferral limit is $22,500 ($30,000 if over 50) to a Traditional or Roth 401(k) in 2023.
If plan rules allow, an employee may contribute above and beyond the $22,500/$30,000 limit
on an after-tax basis, similar to making a nondeductible contribution to a Traditional IRA.
However, total contributions, including employer contributions, may not exceed the combined
limit of $66,000 ($73,500 if over 50). This can allow for a significant sum of after-tax money to
be converted to a Roth IRA or within the plan to the Roth 401(k).
Let’s look at another example:
Employee Salary: $200,000*
Employee Roth 401(k) Deferral: $22,500
Employer Match (5% of salary): $10,000
Total: $32,500
Combined Limit: $66,000
*Note: Roth 401(k)s do not have income limitations like Roth IRAs do!
With the above numbers, the employee can contribute up to an additional $33,500 ($66,000 -
$32,500) on an after-tax basis that can be then converted to their Roth 401(k) or to a Roth IRA
outside of the plan. As with the regular Backdoor Roth, the Mega Backdoor Roth involves the
same 2 steps:
1. Nondeductible/After-tax contribution to employer’s 401(k)
2. Conversion to Roth 401(k) or Roth IRA
Is the Mega Backdoor Roth too good to be true? For most people, the unfortunate answer is
yes. The whole strategy hinges on whether or not your employer’s 401(k) offers both of the
following plan features:
1. After-tax contributions
2. In-service distributions (at least for after-tax funds) OR In-plan Roth 401(k) conversions
While most employers do offer Roth 401(k)s, only a small percentage allow after-tax
contributions, presumably due to the additional reporting and costs that come with it. The
easiest way to find out is to call your 401(k) plan administrator and ask, or look through the
summary plan description for your plan. It’s recommended that you consult a tax professional
prior to performing any Roth conversions or Backdoor Roth strategies.
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