High-income earners can’t contribute directly to a Roth IRA. But thanks to a tax loophole, they can still make contributions indirectly. If you take advantage and maximize your retirement savings, you can save tens or even hundreds of thousands of dollars on taxes over the years. Let's delve deeper into this loophole and the benefits of setting up a backdoor Roth IRA.
- 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 (RMDs), and the distributions are tax-free.
- The lack of RMDs in Roth IRAs also simplifies the record-keeping and tax preparation processes.
- A backdoor Roth can be created by first contributing to a traditional IRA and then immediately converting it to a Roth IRA (to avoid paying taxes on any earnings or having earnings that put you over the contribution limit).
- A backdoor Roth IRA may not be the best idea for those expecting to need the money they’re contributing to the backdoor Roth in the next five years.
Why Bother With a Backdoor Roth IRA?
Both Roth and traditional IRAs let your money grow within the account tax-free. However, 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 it can keep growing indefinitely. This characteristic may 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 record-keeping and makes tax preparation easier. 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. Future tax rates may be higher than current tax rates, so some people would 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 pretax and post-tax contributions, so they have a position in both options.
The Build Back Better Act—passed by the House of Representatives and currently stalled in the Senate—includes provisions that would eliminate or reduce the use of Roth conversions for wealthy taxpayers in two ways:
- Employees with 401(k) plans that allow after-tax contributions up to the annual limit would no longer be able to convert those to tax-free Roth accounts.
- Backdoor Roth contributions from traditional IRAs, as described below, would also be banned. Further limitations would go into effect in 2029 and 2032, including preventing contributions to IRAs for high-income taxpayers with aggregate retirement account balances over $10 million and banning Roth conversions from pretax retirement accounts for high-income taxpayers.
How to Create a Backdoor Roth IRA
In 2021, single taxpayers with a modified adjusted gross income (MAGI) of $125,000 start to face lower and lower Roth IRA contribution amounts as their income increases. If they make $140,000 or more, 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 $198,000 and terminates at $208,000.
In 2022, the limits rise slightly. For singles, the phase-out range becomes $129,000 to $144,000. For marrieds filing jointly, it becomes $204,000 to $214,000.
A traditional IRA, on the other hand, doesn’t limit or prevent people with higher incomes from contributing. The backdoor Roth takes advantage of this fact.
Step 1: Contribute to a traditional IRA
For 2021 and 2022, 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 non-working (or low-earning) spouse, so long as both spouses’ combined contributions (up to $12,000) don’t exceed the working spouse’s income (or both spouses' incomes).
If you've been in a qualified natural disaster, you may have more time to open or contribute to an IRA. For example, the Internal Revenue Service (IRS) announced that victims of the 2021 wildfires in Colorado would have until May 16, 2022, to file various individual and business tax returns and make tax payments. This also meant that affected taxpayers would have until May 16, 2022, to make 2021 IRA contributions.
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 2021 and 2022, for a total of $14,000, as long as each spouse 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 take 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 by paying taxes. Any untaxed amounts in the traditional IRA will result in taxation after the conversion. Keep life simple: Don’t procrastinate on your conversion.
Step 3: Repeat the process, if you wish
Each year in which you can’t fully contribute to a Roth IRA by the regular, front-door way, take advantage of the backdoor Roth.
The age at which you must start taking required minimum distributions (RMDs) from a traditional IRA.
Follow the Rules
- If you already have a traditional IRA to which you made tax-deductible contributions, 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.
- 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.
- 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).
- Fill out IRS Form 8606, Nondeductible IRAs when you file your tax return.
When to Avoid a Backdoor Roth IRA
Remember, a backdoor Roth IRA isn't for everyone. If you don't know the basics, it's bound to backfire. Here are some of the circumstances under which it might not be a good idea to set up a backdoor Roth yourself:
- 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 manage the process correctly and avoid costly tax errors. (If that’s the case, ask a financial planner or tax advisor 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.
What Is a Backdoor Roth IRA?
A backdoor Roth IRA isn't an official retirement account, but it is sanctioned by the IRS. It allows individuals to fund a Roth IRA even when their income is higher than the maximum set by the IRS.
How Does a Backdoor Roth IRA Work?
Taxpayers first make contributions to a traditional IRA account. That account is then immediately converted to a Roth IRA. This allows the individual to avoid paying any taxes on earnings. You can repeat the process every year your income doesn't allow you to contribute to a regular Roth IRA.
Is a Backdoor Roth IRA Worth It?
Yes. Roth IRAs don't have required minimum distributions, which means you can leave your money in the account and let it grow. And the money you do withdraw isn't taxable, which means you pay on the contributions—not the distributions themselves. If you leave the money in a traditional IRA, any earnings are subject to taxes. Just make sure you know the rules so you don't end up paying more than you save.
How Much Can You Backdoor Into a Roth IRA?
You're allowed to contribute the lesser of your earned income or $6,000 in a traditional IRA, which you can then convert to a backdoor Roth IRA. If you're 50 or older, you can also make an additional catch-up contribution of $1,000 each year.
The Bottom Line
Contributing to a Roth IRA through the back door 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 advisor.