What Is a Backdoor Roth IRA?
A backdoor Roth IRA is not an official type of retirement account. Instead, it is an informal name for a complicated but IRS-sanctioned method for high-income taxpayers to fund a Roth, even if their incomes exceed the limits that the IRS allows for regular Roth contributions. Brokerages that offer both traditional IRAs and Roth IRAs provide assistance in pulling off this strategy, which basically involves converting a traditional IRA into the Roth variety.
Keep in mind that this is no tax dodge. When you convert money from a traditional IRA to a Roth IRA, you owe the taxes on the entire amount transferred in that tax year. But as with any Roth IRA, you should owe no further taxes when you withdraw that money after retiring.
- Backdoor Roth IRAs are not a special type of account. They are traditional IRA or 401(k) accounts that have been converted to Roth IRAs.
- A backdoor Roth IRA is a legal way to get around the income limits that normally restrict high earners from contributing to Roths.
- A backdoor Roth IRA is not a tax dodge—in fact, it might even incur higher taxes when it's established—but the investor will get the future tax savings of a Roth account.
Understanding Backdoor Roth IRAs
A Roth IRA or Roth 401(k) allows taxpayers set aside a few thousand dollars a year into a retirement savings account. The money deposited is post-tax. That is, the income on those earnings is paid in the year the money is deposited.
That is different from a traditional IRA or 401(k), which gives the earner an immediate tax advantage by delaying the income taxes on the deposits until the money is withdrawn. But when withdrawals are made, the now-retired accountholder will owe taxes on both the dollars invested and their earnings.
The problem is that people who earn above a certain amount aren’t allowed to open or fund Roth IRAs—under the regular rules, anyway.
If your modified adjusted gross income (MAGI) is well into the six figures, the IRS starts phasing out the amount you can contribute. Once your annual income exceeds a certain threshold, you cannot participate at all. The limits, which vary depending on your taxpayer status (single, married filing jointly, etc.), are adjusted every year or so for inflation.
Traditional IRAs don't have income limits. And, since 2010, the IRS hasn’t had income limits that restrict who can convert a traditional IRA to a Roth IRA.
As a result, the backdoor Roth has become an option for higher-income taxpayers who ordinarily couldn't contribute to a Roth.
How to Create a Backdoor Roth IRA
You can create a backdoor Roth IRA in one of several ways. The first method is to contribute money to an existing traditional IRA and then roll over the funds to a Roth IRA account. Or you can roll over existing traditional IRA money into a Roth—as much as you want at one time, even if it's more than the annual contribution limit.
Another way is to convert your entire traditional IRA account to a Roth IRA account.
A third way to make a backdoor Roth contribution is by making an after-tax contribution to a 401(k) plan and then roll it over to a Roth IRA.
The custodial bank or brokerage for your IRA should be able to help you with the mechanics. If you're dealing with a company 401(k), you can contact the financial services company that manages your company's retirement savings plan.
Only one Roth IRA conversion a year is permitted.
Tax Implications of a Backdoor Roth IRA
Keep in mind, this isn’t a tax dodge. You still need to pay taxes on any money in your traditional IRA that hasn’t already been taxed. For example, if you contribute $6,000 to a traditional IRA and then convert that money to a Roth IRA, you’ll owe taxes on the $6,000. You’ll also owe taxes on whatever money it earns between the time you contributed to the traditional IRA and when you converted it to a Roth IRA.
In fact, most of the funds that you convert to a Roth IRA will likely count as income, which could kick you into a higher tax bracket in the year that you do the conversion. However, you don't have to pay full taxes on the money; a pro-rata rule applies.
Also, the funds you put into the Roth are considered converted funds, not contributions. That means you have to wait five years to have penalty-free access to your funds if you’re under the age of 59½. In this sense, they differ from regular Roth IRA contributions, which can be withdrawn at any time without taxes or penalties.
On the positive side, a backdoor Roth IRA lets you get around these limits:
- Roth IRA income limits: For 2021, if your modified adjusted gross income (MAGI) is higher than $140,000 if you're single ($139,000 for 2020) or $208,000 if you're married filing jointly ($206,000 for 2020) or a qualifying widow or widower, you can’t contribute to a Roth IRA. These limits don’t apply to Roth IRA backdoor conversions.
- Roth IRA contribution limits: For 2020 and 2021, you can contribute $6,000 each year ($7,000, if you are age 50 or over) to a Roth IRA. With a backdoor Roth IRA conversion, these limits don’t apply.
Advantages of a Backdoor Roth IRA
Aside from getting around the limits, why would taxpayers want to take the extra steps involved in doing the backdoor Roth IRA dance?
For one thing, Roth IRAs don’t have required minimum distributions (RMDs), which means account balances can create tax-deferred growth for as long as the account holder is alive. You can take out as much or as little as you want when you want, or leave it all for your heirs.
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.
The main advantage of a backdoor Roth IRA—as with Roths in general—is that you pay taxes upfront on your contributions, and everything after that is tax-free. This characteristic is most beneficial if you think tax rates are going to rise in the future, or that your taxable income will be higher after you retire than it is now.
Special Considerations for Backdoor Roth IRAs
If you're thinking of taking this route, crunch the numbers and carefully consider the pros and cons of a backdoor Roth, especially if you are converting the entire balance of a traditional IRA.