A Roth IRA is a highly desirable retirement plan because it does not tax the growth or income on the investments, even when withdrawn. The problem is that married couples making over $194,000 per year cannot contribute directly to a Roth IRA, which excludes many doctors. Fortunately, there is no income limit on rolling over money from a Traditional IRA to a Roth IRA, nor is there an income limit on making a contribution to a Traditional IRA (although your ability to deduct the contribution phases out over an income range of $98,000 to $118,000).
As a result, many people perform a “backdoor” Roth IRA contribution, in which they contribute money to a Traditional IRA, do not deduct the contribution, and then later roll the money into the Roth IRA. The catch is that if you have any money in any Traditional IRA account that has previously been deducted, including money from a previously rolled over 401(k), then there is a tax consequence to the Roth IRA rollover. If that is the case, then the taxable income on the rolled-over Traditional IRA money is based on a fraction, with the numerator being the value of all previously-deducted contributions in all Traditional IRA accounts and the denominator being the value of all Traditional IRA accounts. It gets a little more technical from there, in terms of the timing and how growth on contributions is treated, and I can discuss those in more detail if anyone is interested.
If you are blocked from performing a tax-free backdoor Roth IRA because you have a significant amount of money in Traditional IRA accounts, then there are two strategies to consider. The first is to roll your Traditional IRA money back into your 401(k), if permitted by your 401(k) plan. Since that brings your previously-deducted Traditional IRA account balance to zero, then a backdoor Roth IRA strategy becomes tax-free again. I would caution against this strategy, though, if your 401(k) plan has high fees. The second strategy is to roll over your Traditional IRA funds into multiple Roth IRA accounts. You could, for example, set up a Roth IRA for each security in your Traditional IRA, and then rollover one security into each Roth IRA. The income on the rollover is determined on the date of the rollover, so if the value of a security in one of your Roth IRAs goes up before the tax deadline the following year, then you leave that Roth IRA alone and pay tax on it. But if the value of a security in a Roth IRA does down before the tax deadline the following year, then you recharacterize that Traditional-to-Roth rollover back into the Traditional IRA. Here is an example:
This strategy is best used with a brokerage that does not charge transfer fees, annual fees or minimum balance fees on the Roth IRA accounts. Further, this strategy should probably not be used with small amounts of money because of the time and hassle involved. In theory, you could use this strategy over multiple years until all of your Traditional IRA funds have been rolled into Roth IRAs under ideal circumstances, thereby making tax-free backdoor Roth IRA contributions available again. Once the tax deadline has passed each year, merge the investments remaining in your Roth IRA accounts into one account as your “keeper” Roth IRA account going forward.
Two final notes:
- If you are using the above strategy, your Roth IRA accounts receiving the different rollover investments should not have any other investments in them. Have a separate, “keeper” Roth IRA account to hold your permanent investments.
- When you owe income tax on the rollover that you keep in the Roth, do not pay the income tax out of your Traditional or Roth IRA accounts, since that decreases the value of those accounts and you cannot replenish the taxes paid back into the account. Rather, pay the tax out of your own pocket.