If you’re a young, high-earning professional in your thirties or forties, you’ve probably heard about the backdoor Roth contribution. It’s one of the most popular strategies advisors talk and write about, because it’s a way to get money into an after-tax retirement account even when you’re above the regular income limits for a Roth contribution. The problem with a strategy that becomes extremely common is that investors start to assume it’s also extremely straightforward. Here are two warnings to keep in mind before completing a backdoor Roth.
Warning #1: Pre-tax IRA money triggers the pro rata rule
The first warning is to be aware of any pre-tax money you have in IRA accounts. People commonly forget about this if they have multiple IRAs, but if you have any pre-tax money in an IRA when you complete a backdoor Roth, you’re going to trigger additional taxes through something called the pro rata rule.
One way to avoid this is to roll the pre-tax IRA money over to a 401(k), empty out the IRA balance, and then complete the backdoor Roth contribution.
Warning #2: Don’t deduct the initial IRA contribution
The other warning is to make sure you don’t deduct the initial IRA contribution before you convert it to the Roth IRA. In a backdoor Roth, that traditional IRA contribution is non-deductible, but a lot of people don’t realize that. When they go to file their taxes, they’ve already moved the money over to the Roth, and they end up claiming a deduction they aren’t actually able to take.
Communicate with your accountant
All of this is much easier to avoid if you’re communicating properly with your accountant. Better yet, if you have an advisor, make sure they have an open line of communication with your accountant and that the two of them are talking about your backdoor Roth before it happens. The accountant may need to track the cost basis for any non-deductible contribution by filing Form 8606, and it’s an easy thing to get lost in the shuffle if you’re not on top of it.
