What is a 'Backdoor Roth IRA'

A backdoor Roth IRA is 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, IRS-sanctioned method for high-income taxpayers to put money in a Roth; it is not the formal name for an official type of retirement account. The best brokers for IRAs and Roth IRAs provide assistance with figuring out these methods. 

BREAKING DOWN 'Backdoor Roth IRA'

A Roth IRA lets taxpayers set aside a few thousand dollars from after-tax income for retirement in a special account where growth and distributions are tax-free. It's important to note that the IRS doesn't allow taxpayers whose modified adjusted gross income is above a certain threshold to participate in a Roth IRA in full. At a higher threshold, they cannot participate at all. 

For example, in 2018, single taxpayers with an AGI between $120,000 and $134,999 have their contributions limited, and the same is true for married taxpayers filing jointly with an AGI between $189,000 and $198,999. Single taxpayers with an AGI of $135,000 or higher and married taxpayers filing jointly with an AGI of $199,000 or higher aren’t normally eligible to contribute at all to a Roth IRA. 

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 convert it 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 a Backdoor Roth IRA Minimizes Taxes

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 see tax-deferred growth 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: The taxpayer has investment earnings from the date of the nondeductible IRA contribution through the date of the conversion or 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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