Backdoor and mega backdoor Roth

In short

A friend of mine once said that the tax code is a house with a lot of side doors, and most folks only ever knock on the front. If you earn a good income, you have probably found that the usual Roth IRA door is closed to you. There are two side doors worth knowing about. The first is the backdoor Roth, which lets you put after tax money into a traditional IRA and then move it into a Roth IRA. The second is the mega backdoor Roth, which uses extra after tax room inside your workplace plan. Whether your plan allows it is spelled out in its summary plan description. The tax bill on a backdoor depends on any other IRA money you hold, and Form 8606 explains how.

The whole of it

What it is

If you are holding a good salary and a Roth IRA form, you may have noticed the income limit. Congress set it so that higher earners cannot contribute directly. The current cutoff is the current figure, which the official source publishes each year, and it changes from year to year. The IRS publishes it each year.

The backdoor Roth is not a special account. It is two ordinary steps done in order. You contribute to a traditional IRA with money you have already paid tax on, and then you convert that money to a Roth IRA. A conversion just means moving the money from one type of IRA to the other. The law that limits direct Roth contributions does not limit conversions.

The mega backdoor Roth is a different door in a different building. Many workplace plans, such as a 401(k), let you save in more than one way. You may have pretax savings, Roth savings, and a third kind called after tax savings. This third kind is not the same as Roth. The dollars you put in have already been taxed, so you get no deduction for them. Any growth on them is taxed when you take it out, unless you move it into a Roth account first. If your plan lets you move those after tax dollars into a Roth account, that is the mega backdoor.

Both of these are legal today, and the IRS has written about conversions in its own publications. But Congress can change the rules, and it has looked at these ideas before. Keep an ear open.

How it works

Let me tell you how the backdoor goes, step by step, the way I would explain it on a porch.

First, you put money into a traditional IRA and do not take a tax deduction for it. That is the after tax part. You report it on IRS Form 8606, which tracks the money you have already paid tax on. Second, you convert the money to a Roth IRA. Third, you file Form 8606 with your return so the IRS knows most of the conversion was tax free. Miss the form and you risk paying tax twice. Do not skip it.

Now the catch that trips up careful people. When you convert, the IRS looks at all your traditional, SEP IRA, and SIMPLE IRA balances together, as if they were one pot. This is called the pro rata rule. If you have old pretax IRA money sitting around, part of your conversion will be taxed. Your after tax share of the total pot decides how much is tax free. The Form 8606 instructions walk through this.

The mega backdoor works inside your workplace plan. Your plan first has to allow after tax contributions. Then it has to allow either an in plan conversion to a Roth account or an in service withdrawal you can send to a Roth IRA. Some plans allow one and not the other. Some allow neither. The way to find out is to ask your plan administrator and to read the summary plan description.

Here is why the mega backdoor can hold so much. There is a limit on what you can put in as an employee. There is also a much larger total limit that counts everything, including your employer's money. The gap between them is the room for after tax savings. That total is set by law each year at the current figure, which the official source publishes each year, and your own employee limit is the current figure, which the official source publishes each year. Your plan may also cap after tax savings below the legal ceiling. So the legal number is only the outer edge.

The numbers, and where to find yours

I will not give you a dollar figure from memory, because these numbers move. Here is where each one lives.

The IRA contribution limit for the year is the current figure, which the official source publishes each year. The IRS posts it, and so does your IRA provider. The Roth income phase out is the current figure, which the official source publishes each year. The employee deferral limit for a 401(k) is the current figure, which the official source publishes each year, and the overall limit on all additions is the current figure, which the official source publishes each year. The IRS announces these each year in a news release, and they also appear on its retirement plan pages.

Then there are numbers only you can find. Look at your pay stub or plan website for what you and your employer already put in this year. Your total additions include your match and any profit sharing. Ask the plan whether it has its own cap on after tax contributions. Check every traditional, SEP, and SIMPLE IRA you own for a balance on December 31. That year end balance is what the pro rata rule uses.

A worked example

Let me tell you about Marcus, a made up executive with a salary of 300,000 dollars. He is too high an earner to put money into a Roth IRA directly. He has no other IRA money at all, which makes his backdoor simple.

Marcus puts 7,000 dollars into a traditional IRA and takes no deduction. He picks 7,000 dollars only to keep the math easy. The real limit is the current figure, which the official source publishes each year, and yours may differ. A few days later he converts the money to his Roth IRA. Between the deposit and the conversion, the account earned 10 dollars.

Here is the math with the inputs shown. His after tax basis is 7,000 dollars. The converted amount is 7,010 dollars. His IRA pot totals 7,010 dollars, and all of it moved. The tax free share is 7,000 divided by 7,010, which is about 99.9 percent. So 10 dollars of the conversion is taxable. Say his tax rate is 35 percent. Then 10 times 0.35 comes to 3.50 dollars in tax. Small potatoes.

Now change one thing. Suppose Marcus also had a rollover IRA with 93,000 dollars of pretax money. The pot is now 93,000 plus 7,000, or 100,000 dollars, before growth. His after tax share is 7,000 divided by 100,000, which is 7 percent. So when he converts 7,000 dollars, only 7 percent, or 490 dollars, is tax free. The other 6,510 dollars is taxable. At 35 percent, that is 6,510 times 0.35, or 2,278.50 dollars. Same steps, very different bill.

Marcus also has a plan that allows after tax savings. Say his employer match is 3 percent of his salary. That is 300,000 times 0.03, or 9,000 dollars, coming from the company. His own pretax savings and the match together use up part of the total limit. The space left for after tax savings is the total limit, less his own deferrals, less the match. He asks his plan administrator to confirm that number in writing. Then he moves those after tax dollars to Roth right away. Little growth builds up, so little is taxed.

Where it goes wrong

I have seen smart people stumble on the same few stones. The biggest is the pro rata rule. Old pretax IRA money can turn a tidy backdoor into a surprise tax bill. Some people move pretax IRA money into a current employer plan, if that plan accepts it. That does take the money out of the pro rata pot. Whether a plan takes such transfers is a question for its administrator, and the year end balance is what counts.

Another stumble is forgetting Form 8606. It feels like paperwork, but it is your proof. Without it, the IRS may treat the whole conversion as taxable.

A third is letting after tax money sit in your plan. The dollars you put in are already taxed, but any growth on them is taxed when you convert. The longer the money sits and grows, the more of the conversion is taxable growth. Moving it quickly keeps that small.

A fourth is assuming your plan allows it. Many do not. Others allow after tax savings but no conversion, which leaves you stuck. Ask first.

There is also the chance that the rules change. Nobody can promise these doors stay open. And these steps can interact with your state taxes, your other accounts, and your income in odd ways. A tax professional who knows your whole picture can look at all of that with you.

Questions to answer before you leave this page

Do you know whether your income puts you over the Roth IRA limit for this year, and where you would confirm that on the IRS site? Do you hold any traditional, SEP, or SIMPLE IRA money that would count toward the pro rata rule on December 31? Have you asked your plan administrator whether your plan allows after tax contributions, and whether it allows an in plan conversion or an in service withdrawal? Do you know your plan's own cap on after tax savings, and how much your employer match adds to your total? Are you ready to file Form 8606 with your tax return? And who will you ask, whether a tax professional or your plan's help line, to check your work before you move a single dollar?