What Is a Backdoor Roth IRA?
A “Backdoor Roth IRA” is not an official type of individual retirement account. Instead, it is an informal name for a complicated method generally used by high-income taxpayers to create a
permanently tax-free Roth IRA, even if their incomes exceed the limits that the tax law prescribes for regular Roth ownership.
Brokerages and investment firms 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 not a tax dodge. When you transfer the assets of a traditional IRA to a Roth IRA, you owe taxes in that tax year on any funds—as well as on earnings and appreciation in transferred assets—that have not been taxed previously. If the IRA has been funded solely with tax-deductible contributions, the entire value of the transferred assets will be taxed. However, as with any Roth IRA, if you follow the rules, then you should owe no further taxes when you withdraw that money.
- Backdoor Roth IRAs are not a special type of account. They are Roth IRAs that hold assets originally contributed to a regular IRA and subsequently held, after an IRA transfer or conversion, in a Roth IRA.
- A Backdoor Roth IRA is a legal way to get around the income limits that normally prevent high earners from owning Roths.
- A Backdoor Roth IRA is not a tax dodge—in fact, it may incur higher tax when it’s established—but the investor will get the future tax savings of a Roth account.
- If you are thinking of establishing a Backdoor Roth IRA, be aware that the U.S. Congress is considering legislation that would reduce their benefits after 2021.
Understanding Backdoor Roth IRAs
A Roth IRA allows taxpayers to set aside a few thousand dollars from their earnings every year in a retirement savings account. The contributed money is after-tax dollars. That is, the funds are earnings that have been taxed in the year when they are contributed to the Roth IRA.
A Roth IRA differs from a traditional IRA. The traditional IRA gives the earner an immediate tax break because taxpayers can take a tax deduction for their contributions in the year they are made and no taxes are due until the money is withdrawn. When withdrawals are made, usually after the retirement, the account holder will owe taxes on both the dollars invested and their earnings. (In some cases, taxpayers whose high incomes or coverage by an employer retirement plan make them ineligible to deduct IRA contributions, contribute after-tax funds to an IRA.)
The problem for high income taxpayers is that individuals 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) exceeds statutory ceilings, set in the low six figures, the law starts phasing out the amount that you can contribute. Once your annual income exceeds a specified threshold, you cannot participate at all.
Traditional IRAs don’t have income ceilings for participation. 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 IRA has become a tax-planning opportunity for higher-income taxpayers who
ordinarily couldn’t contribute to a Roth IRA.
The Build Back Better infrastructure bill, H.R. 5376—passed by the House of Representatives
on November 19, 2021, and currently being considered by the Senate—includes provisions that would reduce some benefits of Roth IRA conversions for all taxpayers starting in 2022. It also would limit contributions and require increased distributions if taxpayers' accounts exceed $10 million in 2029. Ultimately it would eliminate the use of Roth IRA conversions by high-income taxpayers
How to Create a Backdoor Roth IRA
You can create a Backdoor Roth IRA in one of three ways:
- 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.
- Convert your entire traditional IRA account to a Roth IRA account.
- If your company 401(k) plan allows conversions, you can roll your 401(k) account over to a Roth IRA.
The custodial bank or brokerage for your IRA should be able to help you with the mechanics. You can contact the financial services firm that manages your company’s retirement savings plan to
learn if your plan provides this opportunity.
Only one Roth IRA conversion a year is permitted.
Tax Implications of a Backdoor Roth IRA
Keep in mind that in an IRA transfer or conversion to a Roth IRA, 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, claim a deduction for the $6,000 on your tax return, 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 that IRA contribution earned between the date it was contributed to the traditional IRA and the date you converted it to a Roth IRA.
If you make after-tax contributions to a traditional IRA—that is, contribute funds that are non-deductible and taxable that year—such amounts will not be taxed on their transfer to the Roth IRA. But, if most of your IRA contributions were deducted from your income, and if your IRA has accumulated earnings or made investments that have appreciated over a long period, most of the funds and investments that you convert to a Roth IRA will likely count as taxable income at the time of the conversion and could kick you into a higher tax bracket in that year. However, you may not have to pay tax on all the money; a pro rata rule applies to prevent taxing the amounts attributable to after-tax contributions.
Also, the funds that 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 in your Backdoor Roth
IRA if you’re under the age of 59½. Such converted funds 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 the income and contribution limits that apply to traditional Roth IRAs:
- Roth IRA Income Limits—For 2021, if your MAGI is $140,000 or higher and you’re single, or $208,000 or higher and you’re married filing jointly or a qualifying widow or widower, then you can’t contribute to a traditional Roth IRA. These limits don’t apply to Backdoor Roth IRA conversions. (For 2022, the traditional Roth IRA income limit for a single person rises to $144,000, and for those married filing jointly or widowed, $214,000.)
- Roth IRA Contribution Limits—For both 2021 and 2022, you can contribute $6,000 each year (or $7,000 if you are age 50 or older) to a traditional 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? There are a number of good reasons.
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 you can leave it all for your heirs.
Another reason is that a Backdoor Roth contribution can mean significant tax savings over the decades because 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 up front on your converted pre-tax funds and everything after that is tax free. This tax benefit is greatest if you think that tax rates are going to rise in the future or that your taxable income will be higher in the years after your Backdoor Roth IRA is established, especially if you plan to withdraw after a distant retirement date, than it is now.
Is a Backdoor Roth IRA Legal?
Under present law, a Backdoor Roth IRA is legally permissible and respected by the IRS provided tax law requirements are met. However, the pending Build Back Better legislation, if enacted in its current form, will limit conversions to pre-tax contributions in 2022. Beginning in 2029, for high-income taxpayers, the growth of high-value accounts will be restricted. And beginning in 2032, conversions will be eliminated for high-income individuals. High-income taxpayers are defined as individuals having modified adjusted gross incomes—i.e., AGI determined without taking into account certain exclusions and deductions—that exceed specified levels. These levels would be $400,000 for single taxpayers and married persons filing separately, $450,000 for married individuals filing joint returns, and $425,000 for heads-of-households.
How Do I Set Up a Backdoor Roth IRA?
There are three ways. (1) You can put money into a traditional IRA and then roll those funds over into a Roth IRA (or just roll over existing funds already in the IRA). (2) You can convert your whole IRA into a Roth IRA. Or, (3), if you participate in a 401(k) plan that allows conversions, you can roll your 401(k) over (along with pre-tax deferrals and earnings) into a Roth IRA.
Why Create a Backdoor Roth IRA?
If you earn too much money to open a Roth IRA, you may still want to do so for the tax advantage of eventually being able to withdraw funds without paying taxes on the distribution. This is particularly useful if you expect to be in a higher tax bracket in the future. If you can afford to, you can even leave the Roth IRA untouched during your lifetime and provide for its transfer to a heir.
The Bottom Line
If you’re thinking of creating a Backdoor Roth IRA, crunch the numbers and carefully consider the pros and cons, especially if you are converting the entire balance of a traditional IRA. Be aware that if the applicable provisions in the pending Build Back Better legislation become law, conversions will soon be limited to pre-tax contributions only and that, for high-income taxpayers, additional restrictions will apply beginning in 2029.
And be warned: Although IRA funds transferred to Roth IRAs in pre-2018 conversions could be recharacterized as traditional IRA contributions before 2018, the Tax Cuts and Jobs Act (TCJA) of 2017 banned the strategy of recharacterizing converted funds in a Roth IRA back to a traditional IRA contribution in conversions effected after December 31, 2017. So be sure you're sure before you do the conversion.