The Backdoor Roth strategy can be a fantastic tool for your retirement. However, there are 2 problems with the Backdoor Roth that you need to be aware of.

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Mike Bernard, CFP® offers advisory services through KFG Wealth Management, LLC dba Korhorn Financial Group. This information is for general financial education and is not intended to provide specific investment advice or recommendations. All investing and investment strategies involve risk including the potential loss of principal. Asset allocation & diversification do not ensure a profit or prevent a loss in a declining market. Past performance is not a guarantee of future results….(read more)

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The Backdoor Roth is a popular way to contribute to a Roth IRA even if you exceed the income limits. While it’s a smart financial move, there are a few pitfalls to watch out for. In this article, we’ll look at two problems with the Backdoor Roth and how you can avoid them.

1. Pro-Rata Rule

One of the risks of the Backdoor Roth is the Pro-Rata rule. If you have other Traditional IRA accounts, you won’t be able to convert pre-tax money to a Roth IRA tax-free. Instead, the conversion will be subject to taxes based on the ratio of pre-tax and post-tax money in your Traditional IRA accounts.

For example, let’s say you have $100,000 in your Traditional IRA account, of which $20,000 is post-tax, and you make a $6,000 non-deductible contribution to a Traditional IRA to prepare for the conversion to the Roth. In this scenario, the Pro-Rata rule assumes that you have $20,000 in post-tax money out of the $106,000 in your Traditional IRA, meaning that only 18% of the $6,000 conversion will be tax-free, and the remaining 82% will be taxable.

How to Avoid the Pro-Rata Rule: To avoid the Pro-Rata rule, you can roll over your IRA accounts into an employer-sponsored 401(k) plan, assuming your plan allows it. If you don’t have an employer-sponsored plan or your plan doesn’t allow rollovers, you can consider minimizing the balances in your existing Traditional IRA accounts by converting them to Roth IRA accounts, paying taxes on the conversion.

2. The Step Transaction Doctrine

Another issue with the Backdoor Roth is the Step Transaction Doctrine. The Step Transaction Doctrine assumes that if someone could have taken a single step instead of several steps to achieve the same outcome, then they should have taken that single step. All contributions to the Roth IRA via Backdoor Roth must be made in two transactions. The first is a contribution to a Traditional IRA, and the second is a conversion of the Traditional IRA to a Roth IRA. But, the IRS can consider the two transactions to be a single step and can find the Backdoor Roth illegal, leading to hefty taxes and penalties.

How to Avoid the Step Transaction Doctrine: To avoid the Step Transaction Doctrine, the easiest way is to space out the transactions over time. For instance, you can wait a few months after making the initial Traditional IRA contribution before making the conversion to a Roth IRA. Alternatively, you can make your Traditional IRA contribution at the end of the tax year and wait until the following year to convert it to a Roth IRA.

In conclusion, the Backdoor Roth is a great way to contribute to a Roth IRA if you can’t do so directly. However, you need to be aware of the potential issues mentioned above and take steps to avoid them. By doing so, you can ensure that you reap the benefits of the Backdoor Roth while avoiding any unintended tax consequences.