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.

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