Why Backdoor Conversion to Roth

[ finance  ]

I have heard about recommendations of converting regular traditional IRA/401K to Roth via backdoor. After reading an internal post from company I finally understood why.

Differences of Roth vs Traditional.

Roth’s contribution is after tax, which means you pay the taxs when you contribute to Roth. These are the pros and cons of Roth:

  • Roth contribution is only allowed if you met/under certain income conditions. For the 2020 tax year, the income phase-out range for singles is $124,000 to $139,000. For 2021 contributions, the income phase-out range has been increased to $125,000 to $140,000.
  • contribution is after tax;
  • if you withdraw the money from Roth, it could not pay back;
  • when you withdraw, the principal part is tax free.
  • for earning, it would be free of tax and 10% penalty, if your Roth account is at least 5 years old and you met any of following criterions:
    • Made on or after the date you turn 59½.
    • Taken because you have a permanent disability.
    • Made by a beneficiary or your estate after your death.
    • Used to buy, build, or rebuild your first home (a $10,000-lifetime maximum applies).

Traditional generally allows both after-tax contribution and pre-tax contribution, depends on the rule of plan. These are pros and cons of traditional.

  • You could contribute to traditional regardless your income. However your income level do affects how your contribution will be taxed. For example, for 401K, you may contribute upto 19000 pre-tax to 401K in 2020;
  • traditional generally has higher contribution limit than Roth. The maximum amount that an employee or employer can contribute to a 401(k) plan is adjusted periodically to account for inflation. As of 2020 and in 2021, the basic limits on employee contributions are $19,500 per year for workers under age 50 and $26,000 for those 50 and up (including the $6,500 catch-up contribution).
  • traditional has much restricter withdraw conditions and usually associated with taxes and penalties. If you withdraw before 59.
    • When the owner of a traditional 401(k) makes withdrawals, that money (which has never been taxed) will be taxed as ordinary income;
    • Similar as Roth, if you withdraw money before your 59½ you will face 10% penalty, unless some conditions are met;
    • After age 72, account owners must withdraw at least a specified percentage from their 401(k) plans, using IRS tables based on their life expectancy at the time.

Why Converting from Traditional to Roth

Roth looks more attractive than tradition in term of withdraw rules. However, you may not qualify for IRA contribution if your income is too high, which is around 140000 anually for single tax filer.

To circumstance the income limit, backdoor kicks in. You contribute to traditional and than convert to Roth:

  • if the converted money is after-tax, then you don’t need to pay tax for conversion;
  • if the converted money is pre-tax, then you need to pay tax for conversion according to your income tax rate!;
  • if the converted money contains both after-tax and pre-tax. For example, the principal is after-tax and you have earnings from after-tax, the earnings are NOT taxed yet. Then you need to pay tax for the untaxed or pre-taxed part according to your income tax rate!;

After this conversion, the principal and earnings in Roth could be withdrawn without penality and tax generally when you retire.

However not all IRA/401K provider provides this back door.

Written on December 31, 2020