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, IRS-sanctioned method for high-income taxpayers to fund a Roth, even if their income is higher than the maximum the IRS allows for regular Roth contributions. Brokerages that offer both traditional IRAs and Roth IRAs provide assistance with the strategy, which basically involves converting a traditional IRA into the Roth variety.
- Backdoor Roth IRAs are not a special type of account; rather, they are usually traditional IRA accounts or 401(k)s which 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 incur higher taxes when it's established—but it does provide investors with future tax savings.
Understanding Backdoor Roth IRAs
A Roth IRA lets taxpayers set aside a few thousand dollars into a special retirement savings account, in which the assets grow, and eventually can be withdrawn, without incurring any income tax. The problem is that people who earn more than a certain amount aren’t allowed to open or fund Roth IRAs—under the regular rules, anyway.
If your modified adjusted gross income is well into the six figures, the IRS starts phasing out the amount you can contribute; once your annual income gets above 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.
However, traditional IRAs don't have these income limits. And since 2010, the IRS hasn’t had income limits that restrict who can convert a traditional IRA to 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 do 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 amount.
Another way is to convert your entire traditional IRA account to a Roth IRA account. Your IRA custodial bank or brokerage should be able to help you with the mechanics.
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.
Every investor is eligible to do one Roth IRA conversion a year.
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 most 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 you can withdraw 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 2020, if your modified adjusted gross income (MAGI) is higher than $139,000 if you're single ($137,000 for 2019) or $206,000 if you're married filing jointly ($203,000 for 2019) or 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 2019 and 2020, 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 see 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
Taxpayers should be sure to crunch the numbers and carefully consider the pros and cons of a backdoor Roth, especially if they are converting their entire existing traditional IRA. Such IRA conversions could be reversed in a process called a recharacterization. However, the Tax Cuts and Jobs Act of 2017 banned the strategy of recharacterizing a Roth back to a traditional IRA.