If you are a high-income earner who wants to take advantage of the benefits of a Roth IRA, you may have heard of the backdoor Roth strategy. This is a technique that allows you to convert a traditional IRA to a Roth IRA, regardless of your income level. However, if you also have a 401 (k) plan that you want to roll over to a traditional IRA, you may face some tax complications. In this article, we will explain the basics of the backdoor Roth and the 401 (k) to traditional IRA rollover, and how they impact your taxes.
What is a Backdoor Roth?
A backdoor Roth is a strategy that allows you to bypass the income limits for contributing to a Roth IRA. A Roth IRA is a retirement account that lets you contribute after-tax dollars and withdraw them tax-free in retirement, as long as you follow the rules. However, if your modified adjusted gross income (MAGI) exceeds certain thresholds, you cannot contribute directly to a Roth IRA. For 2024, the phaseout ranges are between $146,000 and $161,000 for single filers and $230,000 and $240,000 for married couples filing jointly.
To get around this restriction, you can use the backdoor Roth strategy, which involves two steps:
- Contribute to a traditional IRA, which has no income limits for participation. However, you cannot deduct your contribution if your income is above certain levels. For 2024, the deduction phaseout ranges are between $68,000 and $83,000 for single filers and $109,000 and $129,000 for married couples filing jointly, if you are covered by a retirement plan at work. If you are not covered by a retirement plan at work, the deduction phaseout ranges are between $208,000 and $218,000 for married couples filing jointly, and there is no phaseout for single filers.
- Convert the traditional IRA to a Roth IRA. This is a taxable event, and you will owe income tax on the amount converted, minus any nondeductible contributions. However, if you do the conversion soon after the contribution, and there is no growth or loss in the account, the tax bill will be minimal.
By doing this, you effectively move money from a traditional IRA to a Roth IRA, without being subject to the income limits for Roth IRA contributions.
What is a 401 (k) to Traditional IRA Rollover?
A 401 (k) to traditional IRA rollover is a process of transferring your retirement savings from a 401 (k) plan offered by your employer to a traditional IRA that you control. This can be a good option if you are leaving your job, or if you are unhappy with the investment options, fees, or service of your 401 (k) plan. A rollover can also give you more flexibility and control over your retirement savings, as you can choose any brokerage firm or financial institution to open your IRA, and have access to a wider range of investment choices.
To do a 401 (k) to traditional IRA rollover, you have two options:
- A direct rollover, where your 401 (k) plan administrator transfers the money directly to your IRA provider. This is the preferred method, as it avoids any withholding or penalties.
- An indirect rollover, where you receive a check from your 401 (k) plan and deposit it into your IRA within 60 days. However, this method is risky, as your 401 (k) plan will withhold 20% of the distribution for taxes, and you will have to make up the difference from your own funds to avoid being taxed and penalized on the amount not rolled over.
A 401 (k) to traditional IRA rollover is generally not a taxable event, as long as you follow the rules and complete the rollover within the time limit. However, there are some exceptions, such as if you have after-tax contributions or company stock in your 401 (k) plan, which may require special treatment.
How Do They Affect Your Taxes?
Both the backdoor Roth and the 401 (k) to traditional IRA rollover can have tax implications, depending on your situation. Here are some of the factors to consider:
- The pro rata rule. This is a rule that applies to the backdoor Roth conversion, and it can affect you if you have other pre-tax IRAs, such as a rollover IRA from a previous 401 (k). The rule states that you cannot convert only the nondeductible portion of your traditional IRA to a Roth IRA. Instead, you have to convert a proportional amount of all your IRAs, based on their balances at the end of the year. For example, if you have $100,000 in a rollover IRA and $6,000 in a nondeductible traditional IRA, and you want to convert the latter to a Roth IRA, you cannot just pay tax on the $6,000. You have to pay tax on 94% of the conversion amount, which is the ratio of your pre-tax IRA balance to your total IRA balance ($100,000 / $106,000 = 0.94). This means you will owe tax on $5,640 of the conversion, even though you already paid tax on the $6,000 contribution. The remaining $360 will be tax-free, as it represents the nondeductible portion of your total IRA balance ($6,000 / $106,000 = 0.06). To avoid this problem, you can either convert all your IRAs to Roth IRAs, or roll over your pre-tax IRAs to a 401 (k) plan, if your plan allows it, before doing the backdoor Roth conversion.
- The Roth conversion window. This is the period of time when you can recharacterize or undo a Roth conversion, if you change your mind or want to reduce your tax bill. Prior to 2018, you could recharacterize a Roth conversion up to October 15 of the following year, regardless of when you did the conversion. However, the Tax Cuts and Jobs Act of 2017 eliminated this option, and now you can only recharacterize a Roth conversion by December 31 of the same year. This means you have less time to decide whether a Roth conversion makes sense for you, and you have to estimate your tax situation more accurately. If you do a backdoor Roth conversion early in the year, you may not know your exact income or tax bracket until later in the year, which could affect your decision. Therefore, it may be better to do a backdoor Roth conversion later in the year, when you have more clarity on your tax situation.
- The net unrealized appreciation (NUA) rule. This is a rule that applies to the 401 (k) to traditional IRA rollover, and it can affect you if you have company stock in your 401 (k) plan. The rule allows you to pay tax on the cost basis of the company stock, rather than the fair market value, when you distribute it from your 401 (k) plan. The difference between the cost basis and the fair market value is called the net unrealized appreciation, and it will be taxed at the long-term capital gains rate when you sell the stock. This can result in significant tax savings, especially if the company stock has appreciated a lot. However, if you roll over your company stock to a traditional IRA, you will lose this benefit, and you will have to pay ordinary income tax on the entire value of the stock when you withdraw it from the IRA. Therefore, it may be better to distribute your company stock from your 401 (k) plan and roll over the rest of your 401 (k) balance to a traditional IRA, if you want to take advantage of the NUA rule.
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