Back Door Roth IRA

Many pilots with working spouses realize that investing, taxes, and retirement planning get pretty complicated as income approaches $200K.  Unfortunately, few take advantage of the Back-Door Roth IRA, giving up a serious wealth-building tool and ultimately, over-paying the IRS.

A Back-Door Roth IRA (BDR-IRA) is a Roth IRA with an administrative penalty lap.  Kind of like filling out your medical history for the 369th time before your flight physical.  It’s both necessary and unnecessary, but ultimately, you need to do it to get where you want to be.

As a refresher, here are the main kinds of IRAs:

  • Traditional: Deduct the contribution (up to $6K in 2020 under age 50) from your current income, lower your current tax bill, but pay taxes on the principal and the returns when you start to access them in retirement.
  • Non-Deductible Traditional: Same limits, but you can’t deduct the contribution, so you pay taxes at your marginal rate in the year of the contribution. The principal and returns grow tax-deferred, so you pay taxes on the returns only when you access them in retirement.
  • Roth: Same limits, but you can’t deduct the contribution, so you pay taxes at your marginal rate in the year of the contribution. The principal and returns grow tax-free, so when you access them in retirement, you don’t pay taxes on them.

And here’s why they matter… Assume that you invest $6,000 today at 9%.  Today you’re in the 24% bracket, but in 30 years when you might want to take a distribution to live on, you’ll be in the (hypothetical) 32% bracket…

While Uncle Sam wants to incentivize retirement saving, he doesn’t particularly want the rich to get too many tax breaks (well, maybe the really, really rich…).  As such, there are inflation-indexed income limits for contributions to Traditional and Roth IRAs (T-IRA and R-IRA) to keep the wealthy from getting outsized tax-advantaged savings opportunities.  To complicate matters, the deductibility of a T-IRA contribution is pegged to whether or not your employer offers a tax-advantaged retirement plan (the military does).  Rather than dry your eyes up with all of the details, here’s an easy summary:

Account Type Tax Effect Contribution Limit Adjusted Gross Income Limit / Phase-out Range
Traditional IRA Lower tax now, pay taxes on principal & returns in retirement $6,000 $104K-$124K1
Non-Deductible Traditional IRA No tax break now, pay taxes on returns in retirement $6,000 Unlimited
Roth IRA No tax break now, no taxes due in retirement $6,000 $196K-$206K2
Back-Door Roth IRA No tax break now, no taxes due in retirement $6,000 Unlimited
Assumptions: Tax year 2020; Married filing jointly; under age 50; participant
1 This means that if your employer offers a retirement plan, then as soon as your AGI trips $104K, you start to lose the deductibility of your contribution. At $124K, you cannot deduct the contribution.
2 At $196K of income, regardless of any employer plan, you start to lose the ability to contribute directly to a Roth IRA. At $206K, your options are a NDT-IRA or BDR-IRA.

From Table 1., you can see that the BDR-IRA is basically the offspring of the Non-Deductible T-IRA and the R-IRA.  It has the best trait of the Non-Deductible T-IRA: unlimited income. It also has the best trait of the Roth IRA: no taxes on the compounded returns in retirement.  It’s like being able to Wall and Grind at the same time.  The effect is that there is actually no income limit for a BDR-IRA.

How Do I Contribute to a Back-Door Roth IRA?

Step 1.  Open and contribute (ideally) the annual limit to a Non-Deductible T-IRA at your favorite brokerage (e.g. Fidelity, Vanguard, Schwab, etc.), preferably where you have your R-IRA from those “lean” years when you could contribute directly.  You save yourself a lot of work if you fund the account at one time versus dollar-cost-averaging over time, but more to follow on this later.  I recommend selecting a money market fund or cash so that you generate as close to zero earnings as possible during your money’s short stay in this account (but you don’t want it to lose value either).  You can use the same account each year, it will just have a zero balance when you’re not doing your Back-Door gymnastics.

Step 2. Wait a day.  Seriously, no need to wait any longer.  Log in and transfer the money from the Non-Deductible T-IRA to your R-IRA.  Your brokerage may warn that this could be a taxable event, but that’s unlikely since you paid taxes on the funds prior to opening the Non-Deductible T-IRA and there haven’t been any earnings in the last 24 hours.  Yes, it’s a taxable event, but the bill is $0 on $0 earnings.

Step 3.  Fill out (or have your tax preparer do it) IRS Form 8606.  This is critical and could generate a penalty if skipped.  This form tracks money flowing in and out of Non-Deductible IRAs.  Boom! Back-Door Roth IRA!

For most pilots, this is as complicated as the process gets.  You can make a gazillion dollars and still contribute to a Roth IRA with a quick administrative penalty lap through a Non-Deductible T-IRA and form 8606.

The Pro-Rata Problem

Unfortunately, if you already had money in a Traditional IRA, SIMPLE IRA, or SEP IRA, you may not be able to contribute to a BDR-IRA, or at least not without some extra work or taxes due.  First, the IRS considers all three of those IRAs to have the same tax character- they are made up of pre-tax dollars, so let’s just think of them as pre-tax IRAs for a moment.  Second, even if you have several different pre-tax IRA accounts in your name as in Table 2., the IRS considers them to be a single balance of pre-tax IRA dollars- in this case $60,000.

Account Balance Source
SEP-IRA $5,000 Self-Employed Real Estate Gig
SIMPLE IRA $5,000 Lame Job Before Becoming a Fighter Pilot
Traditional IRA $50,000 Traditional IRA contributions from all those years I didn’t understand the value of Roth…
Table 2. Hypothetical Pre-Tax IRA Accounts

Imagine that you’re trying to create a BDR-IRA.  You’re on Step 3 filling out form 8606 and you realize that you have to account for pre-tax IRA dollars.  I’ll skip to the punchline: because you have pre-tax IRA dollars, the IRS considers any transfer from a Non-Deductible T-IRA to be a pro-rata distribution of the pre-tax dollars you have in your pre-tax IRA accounts and the amount you just deposited into the Non-Deductible T-IRA.  Assuming the $60,000 balance in the Table 2. accounts and a $6,000 contribution to the Non-Deductible T-IRA, the ratio is $6,000 ÷ $66,000 = 9.1%.  That means that when you try to transfer $6,000 from the newly-created Non-Deductible T-IRA, the IRS is going to look at it as 90.9% pre-tax dollars being converted into a Roth IRA and 9.1% after-tax dollars being transferred into the Roth IRA.  You’ll pay your marginal tax rate on 90.9% of the $6,000 because the IRS views it as Roth Conversion.  In the 24% bracket this looks like $6,000 x .919 * .24 = $1323 of ouch!  You already paid 24% tax on the $6,000 when you earned it, and you didn’t actually move money out of any of the pre-tax accounts, so you’ll still have to pay on those dollars when you withdraw in retirement or do Roth conversions later. Double ouch!

Solving the Pro-Rata Problem

You have a couple of choices when solving the pro-rata rule problem.

  1. Get your money out of pre-tax IRA accounts. The easiest is probably to roll the money into the TSP (or your 401k/403b).  The TSP-60 form and information are on the TSP website. (hyperlink to www.tsp.gov).
  2. If it makes sense for your tax planning, bite the bullet by converting them to your Roth IRA and paying the taxes on them at your current marginal rate. WARNING:  Not only are you going pay at your current marginal rate, you could actually bump up your tax bill by tripping into the next bracket or triggering the 3.8% Net Investment Income Tax or .9% Additional Medicare Tax!
  3. If you can’t clear out your pre-tax IRA accounts, don’t attempt a Back-Door Roth IRA yet.  Invest your money in another tax-efficient manner in accordance with your investment policy statement.

Avoiding the Pro-Rata Problem

The best way to manage the Pro-Rata Problem is to avoid it by never putting money into pre-tax IRAs.  To be clear, the TSP or a 401k / 403b are not IRAs.  You can have money in the Traditional TSP (or 401k/403b) and still execute Back-Door Roth IRAs.  Here are some other avoidance maneuvers:

  1. Choose a solo 401k rather than a SEP-IRA for your side-hustle gig. If you have a small business and want to invest some of that income into a tax-advantaged retirement account, a solo 401k might have modest costs compared to a SEP-IRA, but it provides much greater flexibility.
  2. Make sure you’re maxing out your TSP / 401k / 403b contributions before putting money into IRAs. No need to create the BDR-IRA Pro-Rata problem if you haven’t reached the limit in your TSP / 401k / 403b.
  3. Friends don’t let friends choose SIMPLE IRAs. The SIMPLE IRA is a popular, inexpensive, and easy tax-advantaged retirement plan for small businesses.  But it’s a pre-tax IRA and it has a 25% penalty if you remove funds within 2 years of account opening.  If you’re operating a small business or know someone who is, spread the word that SIMPLE IRAs prevent Back-Door Roth IRAs for at least 2 years.
  4. If you’re only temporarily blocked from a BDR-IRA (e.g., SIMPLE IRA 2-year lockout) perhaps stash your money in another tax-efficient investment such as real estate or a low-cost Exchange Traded Fund until you can put it into a BDR-IRA.

Bring It All Together

The Back-Door Roth IRA is a phenomenal tool for building wealth and securing the retirement choices that pilots deserve.  The Back-Door maneuver legally circumvents the income limits on Roth IRA contributions and secures the tax-free growth and retirement distributions that Roth accounts provide.  If you don’t have money in any pre-tax IRAs (T-IRA, SIMPLE IRA, SEP IRA), a Back-Door Roth IRA is a simple 3-step process.  If you do have money in pre-tax IRAs, you need to tread carefully to avoid overpaying that tax man, but a Back-Door Roth IRA may still be an option.  Even if you’re in the 24% bracket today, there’s a great chance you’ll be in a higher tax-bracket as your earnings grow so it’s worth doing the homework to try to max-perform the size of your Roth nest egg.

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