High income earners can't contribute directly to a Roth IRA. But thanks to a tax loophole, they can still contribute indirectly.

If you qualify to take advantage of this tax loophole, you should. The government has clearly sanctioned the practice of contributing to a Roth “through the back door.” It would be more logical to just remove the arbitrary income limitations on Roth contributions, but that's another discussion.

We’re not here to talk about government logic. We’re here to talk about how to maximize your retirement savings. And by maximize, we mean save tens or even hundreds of thousands of dollars on taxes over the years.

Key Takeaways

  • High income earners, who can't contribute directly to a Roth IRA, may be able to contribute indirectly via a backdoor Roth and maximize their retirement savings.
  • Roth IRAs are attractive because they don't have required minimum distributions and the distributions are tax free.
  • A backdoor Roth can be created by first contributing to a traditional IRA, and second, immediately converting it to a Roth IRA (to avoid paying taxes on any earnings and having earnings that put you over the contribution limit).
  • Be sure to follow IRS rules in doing the conversion.
  • There may be reasons not to do a backdoor Roth, but a couple of them can be solved by getting help from a financial or tax advisor.

Why Bother with a Backdoor Roth IRA?

Both Roth and traditional IRAs let your money grow tax free within the account. But Roth IRAs have a couple of advantages over traditional IRAs.

First, they don’t have required minimum distributions (RMDs). You can leave your money in your Roth for as long as you want, which means your money can keep growing indefinitely. This characteristic might be valuable to you if you expect to have enough retirement income from another source, such as a 401(k), and you want to use your Roth as a bequest or an inheritance. The lack of RMDs also simplifies one aspect of your future financial decision-making, record-keeping, and tax preparation. It will save you time and headaches in retirement, when you’d rather be enjoying your free time.

Second, Roth distributions—which include earnings on your contributions—are not taxable. Some people think future tax rates will be higher than current tax rates, so they’d rather pay taxes on their retirement account contributions, as one does with a Roth, than on their distributions, as one does with a traditional IRA or 401(k). Other people want to hedge their bets by making both pre- and post-tax contributions so they have a position in both options.

How to Create a Backdoor Roth IRA

In 2019, single taxpayers with a modified adjusted gross income (MAGI) of $122,000 face lowered Roth IRA contribution limits as their income increases. At $137,000, they can’t contribute at all.

Married taxpayers are further disadvantaged in that their limits aren’t double the single limits. Instead, their ability to contribute phases out with a MAGI of $193,000 and terminates at $203,000, which is the equivalent of $96,500 to $101,500 per spouse.

A traditional IRA doesn’t limit or prevent people with higher incomes from contributing. The backdoor Roth takes advantage of this fact.

To create a backdoor Roth IRA, follow these steps: 

Step 1. Contribute to a traditional IRA

For 2019, you can contribute the lesser of your earned income or $6,000. A working spouse can also contribute up to $6,000 more for a nonworking (or low-earning) spouse, as long as both spouses’ combined contributions (up to $12,000) don’t exceed the working spouse’s income (or both spouse’s incomes).

Individuals who are 50 or older get to make an extra $1,000 in catch-up contributions each year, meaning that a married couple could each put $7,000 in a traditional IRA for 2019, for a total of $14,000, as long as each is at least 50.

If your income is too high to contribute to a Roth, then your income is also too high to deduct your traditional IRA contributions from your tax bill if you or your spouse contributes to a retirement plan at work. If that's your situation, you will already be putting after-tax dollars into your traditional IRA.

Step 2. Immediately convert your traditional IRA to a Roth IRA

Why do you want to do this step immediately? Because if you leave the money in your traditional IRA, you could have earnings, and if you have earnings, you have to pay taxes on those earnings when you do your conversion. If you accumulate enough earnings and then convert your entire account balance, you’ll have an excess contribution you will have to correct. Keep life simple: Don’t procrastinate on your conversion.

In a Roth conversion, you don't really "turn" your traditional IRA into a Roth IRA, you simply move funds from one account to the other.

Step 3. Repeat the process, if you wish

Each year that you can’t fully contribute to a Roth IRA the regular, front-door way, take advantage of the backdoor Roth.  

Follow the Rules

You'll want to make sure that you abide by the IRS rules on your Roth IRA. Here are five tips to help you make sure you do.

  1. If you already have a traditional IRA that you made tax-deductible contributions to, make sure to follow the pro-rata rule. The easiest way to avoid dealing with this rule is to have a zero balance in all traditional IRAs, SEP IRAs and SIMPLE IRAs.
  2. Don’t remove the converted funds from your Roth IRA for at least five years if you are younger than 59½. If you remove them sooner, you will have to pay a 10% penalty unless you qualify for one of the limited exceptions.
  3. Since you can’t contribute to a traditional IRA once you turn 70½, your ability to use the backdoor Roth strategy ends then, too. 
  4. Don’t let your backdoor contribution fall back into your own hands between contributing it to a traditional IRA and moving it to a Roth IRA. You could end up with an unexpected tax bill. Instead, do a trustee-to-trustee transfer (if your traditional and Roth IRAs are not at the same financial institution) or a same-trustee transfer (if both IRAs are at the same institution).
  5. Fill out IRS Form 8606, Nondeductible IRAs, when you file your tax return.

When Not to Do a Backdoor Roth IRA

There may be circumstances under which it might not be a good idea to do a backdoor Roth yourself, including when:

  • You expect to need the money you’re contributing to the backdoor Roth in the next five years. You’ll have to pay a 10% penalty if you withdraw it.
  • You aren’t confident that you can do the process correctly and avoid costly tax errors. (If that’s the case, ask a financial planner or tax adviser for help.)
  • You think the pro-rata rule applies to your situation, but you don’t understand how to do the math to calculate your tax liability. (Again, this is just a DIY problem: Ask a professional for help.)
  • You’ve rolled a 401(k) balance from an old employer into an IRA this year. In that case, if you also do a backdoor Roth, you’ll end up owing taxes.

The Bottom Line

Contributing to a Roth IRA through the backdoor is more complicated than contributing the straightforward way, but it’s your only option if your income exceeds IRS limits. It’s worth the extra steps for many people because a Roth has extra tax benefits that a traditional IRA does not. For help in executing your backdoor Roth IRA contribution correctly, consult a financial planner or tax adviser.