Every few months, a reputable financial news website like MarketWatch, CNBC, or The Wall Street Journal releases an article about the benefits of contributing to a nondeductible IRA and converting that contribution to a Roth IRA (a “backdoor” Roth IRA contribution). However, these articles seemingly gloss over the complexity of the strategy and lead to confusion over its appropriateness. In light of the lack of comprehensive guidance on this topic, this blog discusses a major and often overlooked pitfall that you should know about if you are considering a backdoor Roth conversion.

The nondeductible IRA contribution

Before continuing, I’d like to take a step back to explain a nondeductible IRA contribution and why someone may consider making one. For many working Americans who are saving for retirement through their own contributions, a company-sponsored 401(k) is a primary vehicle for saving pre-tax dollars. As an employee with access to a 401(k) or 403(b), you can contribute up to $22,500 (or $30,000 if you’re 50 or older) to your plan each calendar year. For most people, socking away $22,500 every year may be enough to comfortably reach their retirement goals. For high earners, however, saving $22,500 a year pre-tax may not be enough to ensure a comfortable retirement. Enter the traditional IRA.

The traditional IRA offers an opportunity to save an additional $6,500 (or $7,500 if you’re 50 or older) annually in pre-tax assets. However, if you or your spouse are covered by a retirement plan at work (i.e., 401(k), profit-sharing, SEP IRA, pension, etc.), a traditional IRA contribution loses its deductibility between income levels of $73,000 and $83,000 for single taxpayers and $116,000 and $136,000 for taxpayers married filing jointly. These limits significantly cap the ability of high earners to save pre-tax dollars. High earners still do have the ability to make an IRA contribution, however, they cannot deduct the contribution on their taxes. This contribution is called a nondeductible IRA contribution.

The backdoor Roth conversion

Many personal finance articles highlight the ability to further convert a nondeductible (i.e., after-tax) IRA contribution to a Roth IRA. This backdoor Roth conversion allows high earners to get around the income limits that would otherwise prevent them from being eligible to contribute to a Roth IRA directly. (Eligibility phases out at $138,000 to $153,000 of income for single taxpayers and $218,000 to $228,000 for married taxpayers.) Roth IRAs have many benefits, but the most significant benefit is that the assets contributed to a Roth IRA, along with all future appreciation, will never be taxed again. With no capital gains taxes due on your investment growth and no ordinary income tax realized when you decide to draw from the account, Roth IRAs are a very powerful saving tool.

So, for the successful young couple earning $250,000 in 2023, each spouse can contribute $22,500 to a 401(k). However, if they wanted to save additional funds for retirement, they are prohibited from contributing to a Roth IRA and they cannot make deductible contributions to a traditional IRA. The backdoor Roth IRA conversion discussed above is an attractive option to put away an additional $6,500 for each spouse. And that $6,500 will grow tax-free!

The dilemma

Converting a nondeductible IRA contribution to a Roth IRA is a great planning strategy that will ensure that the account can grow without being required to take distributions during your lifetime and never paying taxes on these assets in the future.

The problem often missed with this strategy is that when converting a traditional IRA to a Roth IRA, all IRA assets (both pre-tax and after-tax) must be considered in the conversion. If you have a rollover IRA from an old 401(k) plan or have contributed pre-tax assets to a traditional IRA in the past, a portion of your Roth conversion will be taxable to you in the current tax year. Consider the two scenarios depicted below.

Scenario 1

An individual has an IRA they have contributed to over prior years when they earned less income than the phase-out amount. This year they make a nondeductible IRA contribution of $5,000 and intend to immediately convert this after-tax contribution to a Roth IRA. What they do not know is that a portion of their $95,000 pre-tax IRA assets will be converted on a pro-rata basis with their after-tax contribution. (This holds true whether they open a new IRA account for the after-tax assets or not.) Assuming they are in the highest 37% federal income tax bracket, this will result in them owing roughly $1,758 in federal taxes for the $5,000 conversion.

Existing IRA BalanceNondeductible IRA
Contribution Limit
Scenario 1$95,000$5,000
$5,000 Conversion$4,750$250
Tax Owed$1,758$0

Scenario 2

This is a much cleaner scenario and the one that’s typically portrayed in articles detailing the benefits of the nondeductible IRA contribution. If the individual does not currently have an IRA, the nondeductible (after-tax) contribution will make up 100% of their IRA balance. When the conversion is made, there will be no tax due and the assets will grow tax-free indefinitely.

Existing IRA BalanceNondeductible IRA Contribution Limit
Scenario 2$0$5,000
$5,000 Conversion$0$5,000
Tax Owed$0$0

What about my 401(k) or 403(b)?

The good news is that qualified plan balances—like your 401(k)—are not considered when making a Roth conversion. An individual can have any dollar amount in a qualified plan without it adversely affecting the conversion. While we typically advise against rolling IRA assets into qualified plan assets (usually due to limited investment flexibility), if an employer plan allows participants to roll existing IRAs into it, it may be prudent to do this prior to executing a Roth conversion. A backdoor Roth conversion using a nondeductible IRA is a complex planning strategy that can have many benefits. Unfortunately, because it is a complex strategy, the drawbacks are often misunderstood and the benefits can be incorrectly overstated. If you are considering a strategy like this, it is important to discuss your unique situation with your tax professional and your Cerity Partners advisor.

Please read important disclosures here.