Personal finance fun: Backdoor Roth IRAs -- when to do it?

May 3, 2023 7:39 PM

I have a traditional IRA that consists of pre-tax 401k contributions from previous employers that I rolled over into it. Should I convert this traditional IRA to a Roth IRA (backdoor Roth)? I do expect my tax rate to increase in the future and I don't think converting would push me into another tax bracket. It seems like the answer is "yes you should" but want to do a gut check.

Also -- there's no point in making post-tax contributions to a traditional IRA if I can't deduct those contributions from my income, right? I think I'd just end up double taxing myself, but at this point I'm just getting generally confused...I don't like the thought of hiring a financial planner but I'm starting to wonder if I should.

posted by dede to Work & Money (8 answers total)

Best answer: tl;dr most people should not do this.

Whether you are "most people" will depend entirely on your personal circumstances (what is your income, what other retirement savings do you have, how old are you, what retirement plans your current employer offers, etc., etc.), but here's the conventional wisdom.

First... forgetting the fact that your question is about a conversion: should you invest new money in a traditional retirement account (e.g. a trad IRAs or trad 401ks) or a Roth account (e.g. a Roth IRA).

Simplifying a little bit (e.g. ignoring employer matches and contribution limits), you should invest $1 of new money in a traditional retirement account if you expect your marginal tax rate to be lower after retirement than it is now now. If your income is lower in retirement then traditional contributions effectively defer tax payment on income to a time when your tax rate will probably be lower. Conversely, if you expect your tax rate to be higher in retirement then you should invest in Roth accounts.

Now, here's the important bit: most people have more income (and therefore pay tax at a higher rate) when they are contributing to retirement accounts (i.e. when they are earning money) than when they have retired (when most people finish earning money, other than social security). Therefore, most people should invest the next $1 they save for retirement in a traditional account rather than a Roth account, all things being equal.

However, the above assumes the tax system doesn't change between now and retirement. If tax rates rise then your marginal tax rate in retirement could be higher than your marginal tax rate now, even if your income is lower in retirement, simply because the income tax schedule has changed. If this happens you'd have been better to invest in Roth accounts and "lock in" the tax rate you paid when you were younger.

But that's a wrinkle. I think it's fair to say that conventional wisdom is: given the choice, most people should make traditional contributions rather than Roth contributions. The tax system could change, so some people make both kinds of contributions to hedge their bets. And if you're lucky enough to have a large income, making both kinds of contributions allows you to contribute much more to retirement accounts (e.g. they max out their trad 401k and a Roth IRA, among other options).

Now... should you convert an existing traditional IRA balance to a Roth IRA?

Let's get the simple case out of the way. Regardless of whether it's a good idea or not, you cannot convert a trad IRA balance to a Roth balance if you can't afford the tax bill associated with that conversion. You will owe the IRS the amount of money you contributed to the traditional IRA multiplied by your marginal tax rate (e.g. 30%) next April if you convert to Roth. If you don't have that cash available (in regular savings, not retirement accounts!), then conversion is not even an option.

If you do have the cash to pay the tax bill, then recall the argument above that your future contributions should probably be traditional contributions. Same thing applies to conversions. You should consider converting your trad balance to Roth if you expect your tax rate in retirement to be higher than it is now. (Note if doesn't matter if you expect your income to be higher later in your working life, which is true of most people and which your question hints if the reason you're considering doing this. It matters only if your income is higher after you retire. This is rare!

So... you should probably not do this!

The reaming (but still rare) reason you might consider doing this is because you want to make Backdoor Roth IRA contributions, i.e. you want to invest new money in a Roth IRA account, but your income exceeds the Roth limit $129,000/year. To make backdoor Roth contributions you should have $0 in traditional IRA accounts otherwise you get a big tax bill. Converting your trad IRA to Roth would give you a trad IRA balance of $0. If your income does not exceed $129,000 or you don't have immediate plans to make new Roth contributions, then this is not relevant. And if your employer offers a 401k, then rolling your trad IRA into the 401k is usually a better option to get your trad IRA balance to $0 and enable the backdoor Roth.

(Note the thing you are considering doing is not a "backdoor Roth", which you call it in the question. It's a thing that, among other consequences, makes a backdoor Roth possible for some people.)
posted by caek at 9:51 PM on May 3, 2023 [6 favorites]

there's no point in making post-tax contributions to a traditional IRA if I can't deduct those contributions from my income, right?

Depends on why you can't deduct them and a couple of other things, but usually no. If the reason you can't deduct them is that your income is too high, and you want to save for retirement, then consider a backdoor Roth, but only after you've rolled your trad IRA balance into your 401k (or, if you have no other option and can afford the tax bill, per my previous answer, converted your trad IRA balance to a Roth IRA).
posted by caek at 9:53 PM on May 3, 2023

The general wisdom is to wait until closer to the end of the year before doing a Roth conversion - this is just so you'll have a better idea of what your income is, so you'll have the best idea if it will/will not push you into a higher tax bracket. Often times salary increases/bonuses are a surprise that make planning earlier in the year hard! And absolutely have the cash on hand to pay the tax bill, without having to withdraw it from either IRA or Roth funds.
For your 2nd question: if you're allowed to make Roth contributions directly (because you're under the income limits), then no, there's no point to making non-deductible IRA contribs just to convert to a Roth. If you're above the income limit, then you may want to consider it.
Bonus info you didn't ask for: taxes are expected to rise in the future, so Roths are even more favorable than they used to be. The Secure Act(s) have also made Roths MUCH more favorable than Traditional IRA/401ks for estate planning...so if there's a good chance that you'll end up leaving some of your money to your beneficiaries rather than spend it all in retirement, you'll want to consider Roths even more. A good financial planner can certainly help!
posted by csox at 7:02 AM on May 4, 2023

I'd seriously look up the comparisions between ROTH and traditional - the post-tax effects of invested ROTHS are so substantial that the difference over decades, assuming best case scenarios for both types, is in the hundreds to low thousands of dollars across hundreds of thousands of dollars invested. In other words, just pick one, they are basically the same.

And if you are bouncing off of income limits for tax deductiblity for IRAs, then maxing your 401k (which lowers your taxable income), over-investing in HSAs (if you are able to have one), and 529 plans (for college expenses if you plan to go back to college or have kids who will) are far better.
posted by The_Vegetables at 8:16 AM on May 4, 2023

Best answer: I have a traditional IRA that consists of pre-tax 401k contributions from previous employers that I rolled over into it. Should I convert this traditional IRA to a Roth IRA (backdoor Roth)?

Just to further clarify, when people refer to "Backdoor Roth" they usually mean the process of making a non-deductible contribution to a traditional IRA and them immediately converting that contribution to Roth. This renders any tax concerns moot, since you won't have invested it in anything that has appreciated in that time. The reason you would do this is if your income is over the maximum allowed for making direct Roth IRA contributions. It is effectively a loophole in current tax law that Congress has so far chosen not to close.

As noted above, having an existing traditional IRA balance complicated this, however. This is because when filing your income taxes you must consider all your traditional IRAs as if the accounts were merged in one traditional IRA, regardless of which account the Roth conversion money came from. For example: you make a $6,000 nondeductible contribution this year. Your previous traditional IRA balance was $54,000, bringing the total to $60,000. When you convert the $6,000 to Roth, only 10% of that (6,000/60,000) would be tax-free; the remainder would be taxed at your normal marginal rate.

As far as whether a Roth conversion, which is what you're contemplating, makes sense -- it probably won't hurt, but may not be a huge advantage. Many people significantly overestimate how much they'll actually end up paying in taxes when retired. And most people don't start making Roth conversions until after they are actually retired, when they don't have W2 income and can more easily manipulate their income to minimize the tax hit of the conversion.
posted by AndrewInDC at 8:31 AM on May 4, 2023

To your first question, unless you want to enable your ability to do the real backdoor Roth (non-deductible tIRA contribution + immediate conversion), I would not convert your tIRA. That would force you to pay your current income tax rate on the conversion, which is likely at one of its highest points. If you do want to convert it, consider waiting until you have a low-income year, between jobs, at retirement, etc.

Most, but not all, 401ks will let you roll a tIRA into them. This is the preferable option, unless your 401k has bad (expensive) investment options.

For your second question, you make non-deductible tIRA contributions only when you can immediately convert them, as said above.

Note that if you mix nondeductible and deductible contributions in the same tIRA, you must keep track, for the reasons AndrewinDC mentioned in his second paragraph. Best to not do it, or open distinct accounts for each.
posted by Dashy at 9:00 AM on May 4, 2023

I think I'd just end up double taxing myself

Paying taxes on income, and then on the income generated by assets you acquire with the initial income, is not double taxation. It's just...taxation. However, the benefits of making nondeductible contributions to a traditional IRA are limited and mostly arise in catastrophic situations, such as bankruptcy or (in some states) a judgment against you. And mixing deductible and nondeductible contributions in one IRA is a recordkeeping nightmare--so listen to the people telling you to open a separate account, if you choose to make nondeductible IRA contributions, and then stay on top of the paperwork.
posted by praemunire at 10:35 AM on May 4, 2023

The only time I think this decision is clear is when you basically know you'll be in a very different tax bracket when you draw on the account. Like, you're planning to move in with your kids or cheaply in Mexico, then your tax rate would go way down and you definitely don't want to convert. Or you're a med student completing your residency and you know you'll be makingthree times your salary, then the Roth is like gold and you want to convert. That said, I think the conservative thing is to keep it in pre-tax. Yes, tax brackets are at historic lows, I think there's a very good chance they will go up in the future. But not, say, double. And if you hit hard times and need to lower your standard of living, the pre-tax choice is a bit of insurance. Someone who is mostly living off social security and withdraws a bit from their 401(k) is going to pay almost nothing in taxes. So effectively it was never taxed going in and barely taxed going out. If you end up flush and have to pay a pretty high marginal rate to withdraw, well, you'll be able to easily afford it. Just my 2 cents.
posted by wnissen at 1:04 PM on May 4, 2023