DEFINITION of 'Backdoor Roth IRA'

A method that taxpayers can use to place retirement savings in a Roth IRA, even if their income is higher than the maximum the IRS allows for regular Roth IRA contributions. “Backdoor Roth IRA” is an informal name for a complicated, but IRS-sanctioned, method that lets high-income taxpayers take a roundabout path to putting money in a Roth; it is not the formal name for an official type of retirement account.

BREAKING DOWN 'Backdoor Roth IRA'

A Roth IRA lets taxpayers set aside a few thousand dollars of after-tax income for retirement in a special account where earnings grow tax-free and distributions aren’t taxed. But the IRS doesn’t let taxpayers whose modified adjusted gross income exceeds a certain amount make the maximum annual contribution to a Roth IRA, and at a slightly higher threshold, high-income taxpayers can’t contribute to a Roth at all.

For example, in 2015, single taxpayers with an AGI of $116,000 or higher have their contributions limited, and the same is true for married taxpayers filing jointly with an AGI of $183,000 or higher. Single taxpayers with an AGI of $131,000 or higher and married taxpayers filing jointly with an AGI of $193,000 or higher aren’t normally eligible to contribute at all to a Roth IRA. (For 2016, add $1,000 to each of these numbers: Limits on contributions start at $117,000 for singles and $184,000 for married couples; cutoffs rise to $132,000 for singles and $194,000 for marrieds.)

The backdoor Roth is an option for higher-income taxpayers because, since 2010, the IRS hasn’t had income limits that restrict who can convert a traditional IRA to Roth IRA. As a result, taxpayers who ordinarily couldn’t contribute to a Roth can instead make a non-tax-deductible contribution to a traditional IRA and then convert the traditional IRA to a Roth IRA.

Another way to make a backdoor Roth contribution is by making an after-tax contribution to a 401(k) plan and then doing a rollover to a Roth IRA.

Why would taxpayers want to take the extra steps involved in making a backdoor Roth contribution? For one, Roth IRAs don’t have required minimum distributions, which means account balances can grow tax deferred for as long as the account holder is alive. Another reason is that a backdoor Roth contribution can mean significant tax savings over the decades since Roth IRA distributions, unlike traditional IRA distributions, are not taxable. Vanguard estimates that the tax savings could reach a quarter of a million dollars by age 90 for a taxpayer who started making maximum backdoor contributions at age 30. That projection assumes the law will continue to allow backdoor contributions.

There is usually a tax bill associated with a Roth conversion, but a backdoor Roth minimizes the tax hit. Since the investor has already paid tax on the money being converted to a Roth IRA, the transaction only creates a tax bill under two circumstances: 1. The taxpayer has investment earnings from the date of the nondeductible IRA contribution through the date of the conversion; 2. The taxpayer has deductible IRA assets, in which case the pro-rata rule applies, which can make a significant percentage of the nondeductible contribution taxable upon conversion.

RELATED TERMS
  1. Roth IRA Conversion

    A reportable movement of assets from a Traditional, SEP or SIMPLE ...
  2. Traditional IRA

    An individual retirement account (IRA) that allows individuals ...
  3. IRS Publication 590-A: Contributions ...

    IRS Publication 590-A offers a detailed look at the contribution ...
  4. Ordering Rules

    The order in which Roth IRA assets are distributed. Assets are ...
  5. Individual Retirement Account - ...

    An investing tool used by individuals to earn and earmark funds ...
  6. IRS Publication 590-B: Distributions ...

    IRS Publication-B outlines the rules for making distributions ...
Related Articles
  1. Retirement

    A Tax Loophole You May Not Want to Fall Into

    HNW individuals can make contributions to Roth and traditional IRAs. But are there consequences?
  2. Retirement

    The Backdoor Way to Qualify for a Roth IRA

    Meet with your tax advisor to find out what a backdoor Roth IRA is. Basically, it's a tax loophole that could help you prepare for retirement.
  3. Retirement

    How to Invest in a Roth IRA Even With a High Salary

    Backdoor conversions offer a way to fund a Roth IRA despite a high income.
  4. Retirement

    Roth IRA Contribution Limits for 2017 Taxes

    Discover the benefits of Roth IRA accounts and how much you can contribute for your retirement. Learn which IRA plan is best for you.
  5. Retirement

    Are You Too Old to Benefit from Opening a Roth IRA?

    You may not be too old to open a Roth IRA. Roth IRAs can offer significant retirement income security and tax advantages, even for older workers.
  6. Retirement

    A Roth IRA Savings Strategy for High Earners

    A backdoor Roth IRA strategy can save high earners tax dollars if implemented correctly.
  7. Financial Advisor

    Roth IRAs Tutorial

    This comprehensive guide goes through what a Roth IRA is and how to set one up, contribute to it and withdraw from it.
  8. Financial Advisor

    Why Some Advisors are Shy to Convert Roth IRAs

    Potential upcoming changes from the Obama Administration could hit rollovers from traditional to Roth IRAs, and that has advisors reluctant to convert.
  9. Retirement

    Roth 401(k) Vs. Roth IRA: Which One Is Better?

    It all depends on your age, your income - and your plans for your retirement nest egg.
Hot Definitions
  1. Preferred Stock

    A class of ownership in a corporation that has a higher claim on its assets and earnings than common stock. Preferred shares ...
  2. Net Profit Margin

    Net Margin is the ratio of net profits to revenues for a company or business segment - typically expressed as a percentage ...
  3. Gross Margin

    A company's total sales revenue minus its cost of goods sold, divided by the total sales revenue, expressed as a percentage. ...
  4. Current Ratio

    The current ratio is a liquidity ratio measuring a company's ability to pay short-term and long-term obligations, also known ...
  5. SEC Form 13F

    A filing with the Securities and Exchange Commission (SEC), also known as the Information Required of Institutional Investment ...
  6. Quantitative Easing

    An unconventional monetary policy in which a central bank purchases private sector financial assets in order to lower interest ...
Trading Center