Roth IRA accounts are one of the most tax efficient retirement savings vehicles. But if your income is over the phase-out limits, you will not be able to contribute directly to your Roth IRA. Enter the so-called “backdoor Roth,” a loophole which allows you to add to your Roth IRA when your income is otherwise over the limit. There are a few critical requirements that you must satisfy to execute the strategy, but if you’re eligible, you could save an extra $6,500 per year in your Roth IRA ($13,000 if you’re married, and more if your age 50 or older). However, this strategy is not without risk.

The basic strategy is a two-step process: first you make a “non-deductible” (i.e. after-tax) contribution to a traditional IRA, for which there are no income phaseouts (unlike a deductible IRA contribution, which has even lower phase-out limits than a Roth). The second step is to execute a Roth conversion, where you move those funds into your Roth account. If the only balance you have in your traditional IRAs is that after-tax money, you wont owe any tax upon converting it to the Roth.

Now for the Caveats:

Be careful if you have existing pre-tax money in any IRA:

If you have any existing traditional IRAs with pre-tax money in them (either from a prior deductible contribution, a rollover from an old employer plan, or earnings on any contributed amounts that haven’t yet been taxed) any conversions you execute will cause you to be taxed on all or a portion of that pre-tax money. You cannot do a conversion of just the after-tax contribution. All conversions must be pro-rata (i.e. based on the proportional amount of pre-tax and post-tax balances).

What to do if you have pre-tax IRA balances:

You could go ahead and convert them and just pay the tax now. This can be a good strategy if it doesn’t put you into a higher tax bracket and you have the cash to pay the tax. Alternatively, if your employer has a 401(k) or 403(b) plan that allows for roll-ins, you can move those pre-tax dollars into your employer plan before you make the non-deductible contribution. This is aptly known in the business as “vacuuming” your IRA. Employer plan balances are not included in figuring the taxability of a Roth conversion.

What if the IRS closes the loophole, or worse…

When Congress passed the law in 2010 to allow for Roth conversions (i.e. converting savings held in a traditional IRA to a Roth IRA by paying the taxes now) they also, perhaps inadvertently, created a loophole for higher earners to make regular Roth contributions. To be clear, there is no such thing as a “Backdoor Roth” in the eyes of the IRS, which has never issued any guidance on the strategy and whether or not it violates long held rules against “step-transactions.” According to the IRS, any multi step transaction involving individual steps which are permitted in isolation, but when combined to produce an outcome that is otherwise prohibited, are not allowed. It follows that, if you earn too much to contribute directly to a Roth, you shouldn’t be allowed to execute a step-transaction that produces the same prohibited result (i.e. a backdoor Roth contribution). Its possible, even likely, that congress or the IRS will grandfather in previous backdoor contributions in the event they want to prohibit the practice going forward, given how common the practice is. But if they don’t, you could owe a 6% excise tax for overfunding your Roth account, which would be costly, especially if applied to years of compounded earnings!

Should I make a backdoor Roth Contribution?

You should consult your CPA and weigh the risks. I generally recommend to clients who wish to pursue this strategy, that they separate the two steps of the transaction by a period  (a year would be best) and furthermore that they invest the non-deductible contribution during that period. By doing this, you’ll end up paying some tax on the earnings when you execute the conversion, but you will have broken up the two-steps.

Optimizing Roth contributions and conversions can produce significant tax savings over a lifetime. Navigating the many factors involved (see Optimizing Traditional vs Roth Retirement Savings) is one of the major benefits of working with a knowledgeable financial planner who understands these intricacies and keeps up to date.