What is a backdoor Roth IRA?

Roth IRAs offer an enticing retirement savings opportunity for many investors – but, as a high-income earner, you might be dissuaded by the limitations that come with it. While making a direct Roth IRA contribution might not be an option for you depending on your income, that doesn’t bar you from the benefits of these accounts.

So what are your options if you exceed the income limits?

The backdoor Roth IRA strategy is a well-known tax loophole that offers high-income earners a way to tap into the tax advantages of these accounts. But before we delve into this investment maneuver, let’s take a step back to understand the fundamentals of IRAs.

An individual retirement account is a popular investment vehicle often used to save for retirement while reducing tax liability. However, not all IRAs are made the same, and understanding the difference is crucial to working toward your goals.

Generally speaking, there are two types of IRAs: traditional and Roth.

With a traditional IRA, assuming you meet the deduction requirements, the money you put in counts as tax-deductible contributions on state and federal returns for that year. Consequently, any “withdrawals” or deductions you make will be taxed at your ordinary income tax rate. On the other hand, Roth IRAs tax your contributions but allow for tax-free distributions during retirement.

Traditional IRAs are often used to help lower an investor’s overall taxable income in a given contribution year. However, if an investor withdraws the money before age 59½, they will generally have to pay a 10% early withdrawal penalty in addition to the normal tax rate.¹ Unlike traditional IRAs, Roth accounts allow for tax- and penalty-free distributions before this age, so long as you only withdraw your contributions and not the earnings.

But Roth IRAs also have some disadvantages – namely, their income-eligibility restrictions. According to the IRS, investors cannot make a Roth IRA contribution if their Modified Adjusted Gross Income is more than $153,000 in 2023. For married couples, this MAGI limit is set at $228,000.² These restrictions are why many investors choose a backdoor strategy. But what exactly is a backdoor Roth IRA conversion?

A backdoor Roth IRA refers to a strategy in which a high-income investor converts a traditional IRA into a Roth IRA. In addition to working around the Roth IRA contribution limit, this offers distinct advantages, such as:

• Tax-free growth: Because you pay taxes on each Roth IRA contribution, the account is allowed to grow tax-free. That means you won’t have to pay taxes on distributions, which could be beneficial if you expect to be in a higher tax bracket later in life.
• No Required Minimum Distributions: Money left in a Roth account can grow indefinitely because you won’t be required to withdraw it at a certain age. This might be especially useful to those who expect to have enough retirement income from outside sources, such as a 401k.

A backdoor Roth IRA conversion is relatively straightforward, but there are two primary ways to go about it:

Generally, you’d start by opening a traditional IRA account or using an existing one to make a nondeductible contribution. While this retirement account doesn’t have an income limit for nondeductible contributions, it does have an annual contribution limit to be aware of ($6,500 if you’re younger than 50, $7,500 if you’re 50 or older).³ Once you’ve made your contribution, you can immediately convert the account into a Roth IRA to take advantage of tax-free distributions because Roth conversions do not have any income limitations.

The second method involves contributing after-tax money into your employer-sponsored 401k plan, and then immediately converting that money into a Roth within the 401k account or a Roth IRA. This can provide a significant boost to your retirement savings as 401k plans have a maximum contribution limit of $66,000 in 2023 between the employee and employer match. For high-income earners, it typically makes sense to contribute the maximum elective deferral amount of $22,500 as a pretax elective deferral.⁴ Then, if they can afford to save more and would like to take advantage of the mega backdoor Roth, they can add up to $43,500 more (less any employer match) as after-tax contributions. 

While anyone can convert a traditional IRA into a Roth account, it’s not advisable to try this without the help of a professional. When you work with a financial planner, they’ll guide you through the process carefully and methodically. That way, you can work with your tax professional to help avoid potential penalties or extra taxes.

To perform this backdoor conversion, your financial planner and tax professional will help you complete three basic steps:

1.    Contribute to your traditional IRA

Start by opening a new traditional IRA or using an existing one. If you choose the latter option, existing funds might impact your tax liability. In either case, make a nondeductible contribution. To do this, you’ll also need to file IRS Form 8606, which lists your nondeductible contributions.
 

2.    Convert the contribution amount to a Roth IRA

Once you made your contribution, immediately convert the account into a Roth IRA to prevent these funds from generating gains in the traditional IRA. While there’s no real-time limit on a backdoor conversion, you could potentially owe taxes on any accumulated gains.
 

3.    Prepare for tax season

If you’ve only made nondeductible contributions to your IRA, you can convert without any tax liability. However, if you used an existing traditional IRA with a balance of pretax money in the account, or if you maintain any SEP, simple or traditional IRA with a balance, you will need to be aware of the pro rata rule and a portion of your conversion will be taxable as income.

While a backdoor conversion can help you get around the income limitations of Roth IRAs, it can’t help you avoid paying taxes on pretax contributions. For instance, you contributed the full $6,500 to your traditional IRA, and then you claimed a deduction on the full amount. You can’t then convert the funds to a Roth IRA without paying back taxes on the $6,500.

A backdoor Roth IRA strategy isn’t the best choice for everyone – even if you’re a high-income earner. If you don’t understand the rules and implications of the conversion, it could end up backfiring with costly consequences. To help ensure you comply with the IRS, your tax professional and financial planner will help you understand these key rules:

If your account balance contains both pretax and after-tax amounts, any distribution, including a conversion, will generally include a pro rata share of both. This ratio is based on the percentage of after-tax dollars in the entire balance in all of a person’s traditional IRAs, SEP IRAs and simple plans. For example, if your account balance is $100,000, consisting of $80,000 in pretax amounts and $20,000 in after-tax amounts and you request a conversion of $6,000, then $4,800 of the conversion is taxable as income because that is 80% of the $6,000. If you have any IRAs with a pretax balance, the best way to get around the pro rata rule is to roll these traditional IRA assets into your employer-sponsored 401k plan if your employer plan allows for rollovers.

Roth accounts are also subject to a five-year rule, which helps determine if the distribution will be considered tax-free. The rule also applies differently to contributions versus conversions. For contributions, the five-year rule determines whether earnings can be withdrawn tax-free. For conversions, the five-year rule determines whether the converted principal can be withdrawn penalty-free and the five-year time period applies to each conversion.

To qualify as a tax-free qualified distribution, two requirements must be met:

1. The distribution much meet the five-year holding period (five tax years must pass from when the first contribution to the Roth IRA was made)
2. The distribution must be made on or after the owner is age 59½, after the death of the owner, after becoming totally disabled or for a qualified home purchase up to $10,000

If you’re under the age of 59½, earnings will be taxed and subject to a 10% penalty. Even if you’ve reached age 59½, unless five years have passed, the earnings are taxable but not subject to the 10% penalty.

Answering this question is difficult as every situation has unique circumstances – that’s why it’s important to partner with a financial planner. You’ll need to look at a number of considerations, such as how much savings you’ll need to have and which buckets are most appropriate. In general, there are a few situations in which a backdoor Roth IRA strategy might just backfire:

1. You try to manage the process and taxes on your own
2. You’ll need the money you’re contributing in the next five years
3. You don’t know how to calculate your pro rata tax liability
4. You’ve already rolled a 401k balance into an IRA this year
    

If you relate to any of these scenarios, it’s best to speak with a trusted financial advisor before attempting a backdoor conversion.