Taxes.
One of the most hated aspects of personal finance, but without them, we don’t have a country.
So, unless you want to get in serious trouble and potentially go to jail, you must pay Uncle Sam his due.
The US tax code is infamous for its complexity, resulting in over 510,000 tax accountants, over 1.7 million bookkeepers, 79,000 IRS employees, and hundreds of thousands of workers in other related jobs (tax associates, tax assistants, tax advisors, etc.) in the US. And that’s not counting the 0.6% of the average 1,872 annual hours of full-time work it takes 134 million taxpayers to file tax returns.
All told, nearly 1 in 50 American workers’ jobs relate to taxes, be it collecting taxes, reporting them, or helping the rest of us minimize and reduce them.
Table of Contents: The Pro-Rata Rule
- Major Tax Deduction – Contributing to Retirement Plans
- Most Widely Used Retirement Plans
- Roth IRAs and Roth 401(k) Plans
- Income Limits on Roth IRA Contributions
- Workaround – “Backdoor” Roth Conversion
- The IRA Pro-Rate Rule Bites
- Avoiding the Pro-Rata Rule Trap
- Financial Professionals Weigh In
- Find Financial Advisors on Wealthtender
Major Tax Deduction – Contributing to Retirement Plans
Over time, our tax law was crafted to try and promote what lawmakers think is good for the country (or at least for their constituency and/or donors).
One such “good” is that people save for their own retirement.
Enter tax deductions for retirement plan contributions such as Individual Retirement Arrangements (IRAs) and 401(k) plans. However, not wanting to let high-income earners take too much advantage, the IRS sets annual contribution limits for these plans.
For 2023, the IRA contribution limit is $6500 ($7500 if you’re over 50). However, there are limits on how much you can make and still deduct your IRA contribution. In 2023, the deductibility phases out if your Modified Adjusted Gross Income (MAGI) is above $138k if you’re single, head of household, or married, filing separately (and didn’t live with your spouse that year), reaching zero deductibility at $153k MAGI.
For married filing jointly or qualifying widow(er), deductibility starts phasing out at $218k MAGI and reaches zero at $228k MAGI.
The 2023 limits for 401(k) plans are a bit more complicated because there are three separate limits.
- Employee deductible contribution limit of $22,500 ($30,000 if you’re over 50)
- Employer deductible contribution limit of 25% of employee compensation
- Total contribution limit of $66,000 ($73,500 if you’re over 50)
Once you reach your employee deductible contribution limit, if that plus your employer match is less than the total limit (if the plan allows it), you can add an after-tax contribution up to your total limit.
Most Widely Used Retirement Plans
According to the Investment Company Institute (ICI), there are 60 million active 401(k) participants. There are also about 10 million 403(b) participants and about 7 million 457(b) participants (these are the nonprofit/government version of the 401(k)).
US Census data shows about 52.6% as many IRAs as 401(k)/403b)/etc. accounts, so there are likely about 41.5 million IRAs.
Roth IRAs and Roth 401(k) Plans
A new type of IRA, the Roth IRA, was introduced in 1998.
Eight years later, in 2006, the Roth 401(k) was introduced.
The difference between Roth and traditional accounts is that Roth contributions are done with after-tax dollars. Instead of the traditional IRA (or 401(k)) contribution deduction, the Roth’s tax benefit is that no taxes are ever owed on any withdrawals, including on earnings.
Another benefit of the Roth IRA is that once the account has been open for five years, you can withdraw your contributions tax- and penalty-free, no matter your age.
According to ICI, about 1/3 of IRAs are Roth IRAs, so we can estimate that’s about 14 million Roth IRAs.
Per CNBC, about 28% of 401(k) participants make Roth contributions, so if the same holds for 403(b) and 457(b) plans, there are about 22 million Roth plans of these types.
Income Limits on Roth IRA Contributions
The same contribution limits apply to the Roth versions as to the traditional IRA and 401(k).
However, Roth IRAs are limited in another way. You cannot contribute directly to a Roth IRA if your MAGI is too high. The income limits for 2023 are $153k for single filers and $228k if married and filing jointly.
Workaround – “Backdoor” Roth Conversion
With millions of tax professionals, it wasn’t long before someone figured out a clever and elegant workaround called the “backdoor” Roth conversion.
Since you’re precluded from making a Roth contribution and/or a deductible traditional IRA contribution, you follow this two-step process:
- Make a non-deductible, after-tax contribution into a traditional IRA.
- Immediately roll the money over from the traditional IRA to a Roth IRA (since you do this immediately, there are no earnings, so all the money transferred is after-tax)
However…
The IRA Pro-Rate Rule Bites
Uncle Sam isn’t one to take such shenanigans lying down.
The IRS has a counter to this backdoor trick called “the pro-rata rule.”
What this rule does is treat all money you have in however many IRAs you own as if it were in a single account.
Then, when you roll money over from a traditional to a Roth IRA, the IRS treats the rollover as if it has a proportional fraction of pre-tax and after-tax money as your overall IRA holdings, i.e., only a pro-rata amount is considered after-tax.
The calculation goes like this:
(Presumed After-Tax) = (Rollover Amount) x (Total After Tax)/(Total Pre- and After-Tax)
The following table shows some examples if all your IRA money is pre-tax.
If you already have some pre-tax and some after-tax IRA money, the results change for the better:
The silver lining is that by paying taxes in the present on the large fraction of the backdoored money, you’re reducing the number of pre-tax dollars in your IRAs.
Avoiding the Pro-Rata Rule Trap
Just like with any other arms race, here too, each advance made by one side is soon negated or worked around by the other.
Tax pros have come up with four ways to avoid the pro-rata rule. As you’ll see, however, none provide a complete solution for everyone.
- Contribute only to Roth IRAs: If you know in advance that you’ll end up wanting to make Roth IRA contributions and will likely earn too much, you could make all your IRA contributions into Roth accounts. The drawbacks are that (a) this requires very early planning, and (b) you give up IRA-contribution tax deductions throughout your career in return for having all your IRAs be tax-free Roths.
- Convert traditional pre-tax IRAs to Roth IRAs: Before trying a backdoor Roth conversion, you can convert all your pre-tax IRA money into Roths. The problem here is that every dollar you convert counts as income in the year you convert it, leading to potentially extremely high tax bills (due to the higher income your taxable income is higher, and you may even be pushed into higher tax brackets).
- Contribute to Roth 401(k) instead: Since Roth 401(k) contributions are allowed regardless of your income, you can make Roth 401(k) contributions instead of the backdoor IRA conversion. Here the problem is that if you already max out your 401(k) contribution you can’t do this.
- Roll pre-tax IRAs into pre-tax 401(k) plan: If your 401(k) plan allows rolling IRA money over into it, this is the most elegant solution. Since the IRS does not lump 401(k) and IRA money together for the purpose of the pro-rata rule, you roll all your pre-tax IRA money into a pre-tax 401(k) (which isn’t a taxable event). Then, make the two-step backdoor Roth conversion described above.
Financial Professionals Weigh In
Angela Dorsey, CFP®, MBA, Financial Planner, Dorsey Wealth Management, says, “I’m super conservative with backdoor conversions – I don’t want clients to get in trouble with the IRS! I only do backdoor conversions if there are no pre-tax IRAs so there’s no issue. If clients do have pre-tax IRAs, I suggest starting with a tax-efficient Roth conversion strategy that doesn’t push them into a higher tax bracket.”
Matt Pruitt, CFP®, CFA®, Exhale Wealth Management emphasizes, “Rolling your pre-tax IRAs into your pre-tax 401(k) is a massively under-utilized strategy, and not all advisors are motivated to tell you about it. That’s because it reduces “assets under management” or AUM, which reduces fees for many advisors. If working with such a financial advisor, you may need to bring this to their attention proactively.”
Christopher Johns, Wealth Advisor, Spark Wealth Advisors, agrees, “For clients who have pre-tax IRAs, I recommend rolling those IRAs into their 401(k) as mentioned above. I also advise high-earning clients who transition to a new job and don’t already have pre-tax IRAs to keep their old 401(k) where it is or roll it into their new 401(k), avoiding the creation of pre-tax IRA balances.”
Cobin Soelberg, MD, JD, Founder and Principal Advisor, Greeley Wealth Management, expands, “I work primarily with physicians who, as a rule, earn too much to contribute to Roth IRAs directly. They’re also in high tax brackets, so Roth 401(k) plans tend not to make the most sense during their highest-earning years. However, as noted above, getting some money into post-tax Roth accounts is a huge win. For almost every client, we discuss backdoor Roth IRA contributions each January. The first year is when we align everything. If they have moderate balances in pre-tax IRAs, we convert those into Roths. If the balances are too large, we move them into a workplace or solo 401(k). Then, once the pre-tax IRA balance is $0, we start making annual backdoor Roth conversions.”
Avoiding the Pro-Rata Rule Trap
There’s a lot to like about Roth IRAs.
This is why people try to get around the income limits imposed on direct Roth IRA contributions through the so-called backdoor conversion.
The problem is that if you have a lot of money in pre-tax IRAs, you’d be trapped by the pro-rata rule and have to pay taxes on much (or nearly) all of the backdoored money. If you roll pre-tax 401(k) money into a pre-tax IRA, this problem becomes worse.
The above provides four ways to avoid falling into this trap, though each path has its own limitations and conditions.
Disclaimer: This article is intended for informational purposes only, and should not be considered financial advice. You should consult a financial professional before making any major financial decisions.
About the Author: Opher Ganel, Ph.D.
My career has had many unpredictable twists and turns. A MSc in theoretical physics, PhD in experimental high-energy physics, postdoc in particle detector R&D, research position in experimental cosmic-ray physics (including a couple of visits to Antarctica), a brief stint at a small engineering services company supporting NASA, followed by starting my own small consulting practice supporting NASA projects and programs.
Along the way, I started other micro businesses and helped my wife start and grow her own Marriage and Family Therapy practice. Now, I use all these experiences to also offer financial strategy services to help independent professionals achieve their personal and business finance goals.
Connect with me on my own site: OpherGanel.com and/or follow my Medium publication: medium.com/financial-strategy/.
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Disclaimer: This article is intended for informational purposes only, and should not be considered financial advice. You should consult a financial professional before making any major financial decisions.