What Is a Backdoor Roth IRA?

Want to contribute to a Roth IRA, but concerned that you earn too much money? Don’t fret, high-income earners still have a way to do it using something called a backdoor Roth IRA!

A Backdoor Roth IRA is a method used by individuals to contribute to a Roth IRA even when their income exceeds the limits set by the IRS for direct Roth IRA contributions. Roth IRAs are attractive retirement accounts because they offer tax-free growth and tax-free withdrawals in retirement, but they come with income limits that prevent high earners from contributing directly to them.

Here’s how the Backdoor Roth IRA process generally works:

1. Contribution to a Traditional IRA: Regardless of income level, you make a non-deductible contribution to a Traditional IRA. Non-deductible means you don’t get to deduct this contribution from your taxable income.
2. Conversion to Roth IRA: Shortly after making the non-deductible contribution to the Traditional IRA, you convert that Traditional IRA into a Roth IRA. The conversion process involves moving your money from the Traditional IRA to a Roth IRA.
3. Tax Implications: Since the original contribution to the Traditional IRA was non-deductible, you’ve already paid taxes on the money you contributed. Therefore, you generally won’t owe taxes on the contribution portion of the conversion. However, any growth in the Traditional IRA between the time of contribution and conversion may be subject to taxes.
4. No Income Limits on Conversions: The IRS does not place income limits on who can convert a Traditional IRA to a Roth IRA, which is why this backdoor method is possible.

It’s worth noting that the Backdoor Roth IRA strategy is more beneficial in situations where there are little to no earnings on the Traditional IRA contributions before the conversion, minimizing the tax impact. Also, taxpayers should be aware of the pro-rata rule if they have other pre-tax IRAs, which could complicate the tax situation and possibly increase the tax liability upon conversion.

Due to its complexity and potential tax implications, it’s often recommended to consult with a tax professional or financial advisor when considering a Backdoor Roth IRA to ensure it’s done correctly and is the right strategy for your financial situation.

Roth IRA Contribution Limits

For 2024 the income phase-out range for taxpayers making contributions to a Roth IRA is increased to between $146,000 and $161,000 for singles and heads of household, up from between $138,000 and $153,000. For married couples filing jointly, the income phase-out range is increased to between $230,000 and $240,000, up from between $218,000 and $228,000. The phase-out range for a married individual filing a separate return who makes contributions to a Roth IRA is not subject to an annual cost-of-living adjustment and remains between $0 and $10,000.

Is a Backdoor Roth IRA Conversion Right for You?

Here’s a breakdown of who should and should not consider a Backdoor Roth IRA conversion:

Who Should Consider a Backdoor Roth IRA Conversion

1. High Earners: Individuals whose income exceeds the limits for direct Roth IRA contributions. The Backdoor Roth IRA provides a way to enjoy the benefits of a Roth IRA, such as tax-free growth and withdrawals.
2. Those with Minimal Pre-tax IRA Funds: Individuals with little to no existing pre-tax money in Traditional, SEP, or SIMPLE IRAs will face minimal tax implications during the conversion, making it more beneficial.
3. Young Investors or Those Far from Retirement: Individuals with a long time horizon before retirement can benefit significantly from the tax-free growth offered by a Roth IRA.
4. Those Expecting Higher Taxes in Retirement: If you anticipate being in a higher tax bracket in retirement, paying taxes now at a lower rate could be advantageous.
5. Those Seeking Tax Diversification: Investors who want to balance their retirement savings between pre-tax and after-tax accounts to manage future tax liabilities.

Who Should Not Consider a Backdoor Roth IRA Conversion

1. Individuals with Large Traditional IRA Balances: Due to the pro-rata rule, those with substantial pre-tax funds in Traditional, SEP, or SIMPLE IRAs may face significant tax liabilities when converting, potentially outweighing the benefits.
2. Those in High Tax Brackets Now: If you’re currently in a high tax bracket and expect to be in a lower one in retirement, the immediate tax cost of a conversion might not make financial sense.
3. Those Needing the Funds Soon: Since Roth IRAs require earnings to stay in the account for at least five years to qualify for tax-free withdrawal (and you must be 59½ or meet other qualifying conditions), those needing access to their funds sooner may find this option restrictive.
4. Individuals with No Means to Pay the Tax on Conversion: If you can’t pay the conversion tax from outside sources and need to use the funds from your IRA, it might diminish the value of converting.
5. Those with Uncertain Financial Futures: If your financial situation is unstable or you anticipate needing access to your retirement funds for emergencies, the flexibility of Traditional IRA withdrawals might be more suitable, despite the immediate tax deduction benefits.

Before proceeding with a Backdoor Roth IRA conversion, it’s crucial to consult with a financial advisor or tax professional. They can provide personalized advice based on your financial situation, help you understand the implications of the pro-rata rule, and determine whether a Backdoor Roth IRA conversion aligns with your retirement planning goals.

The Pro-Rata Rule

The pro-rata rule is a tax rule that comes into play when you convert or roll over money from a tax-deferred retirement account (like a Traditional IRA) to a Roth IRA and you have both pre-tax and after-tax dollars in any of your Traditional IRAs. The pro-rata rule is significant because it determines how much of the conversion is taxable when you have a mix of deductible (pre-tax) contributions and nondeductible (after-tax) contributions across your IRAs.

Here’s a simplified explanation of how the pro-rata rule works:

1. Aggregation of IRAs: For the purposes of the pro-rata rule, the IRS requires you to aggregate all your Traditional IRAs, SEP IRAs, and SIMPLE IRAs to calculate the taxable portion of a conversion to a Roth IRA. This means you cannot selectively convert only after-tax contributions to a Roth IRA and avoid taxes.
2. Calculating the Taxable Portion: The pro-rata rule calculates the ratio of after-tax contributions to the total balance of all your IRAs. This ratio determines what portion of the conversion is considered taxable. Essentially, every conversion contains a proportional mix of taxable (pre-tax contributions and earnings) and non-taxable (after-tax contributions) amounts.
3. Formula: The formula to determine the taxable portion of a conversion is:Taxable Amount=Total Pre-Tax IRA FundsTotal IRA Funds×Amount ConvertedTaxable Amount=Total IRA FundsTotal Pre-Tax IRA Funds?×Amount Converted
4. Example: If you have $100,000 in your IRAs, of which $20,000 are nondeductible contributions (after-tax), and you convert $10,000 to a Roth IRA, not all of that $10,000 conversion is tax-free. Instead, you would calculate the taxable amount based on the proportion of pre-tax and after-tax dollars in all your IRAs.
5. Impact: The pro-rata rule ensures that you cannot convert only after-tax amounts to a Roth IRA tax-free while leaving pre-tax amounts untouched. It proportionally taxes conversions based on the makeup of your entire IRA holdings.

Because of the pro-rata rule, it’s crucial to carefully plan conversions and understand the tax implications, especially if you have a mix of pre-tax and after-tax amounts in your IRAs. It often makes the Backdoor Roth IRA strategy less beneficial for individuals with significant pre-tax IRA balances due to the larger tax liability incurred during conversion. Consulting with a financial advisor or tax professional can help navigate these complexities.

Final Thought

Doing a backdoor Roth conversion can make sense in the right situation. Just be sure to consult with a tax professional before doing this.

“Remember, in general, tax rates are likely to go higher over the years no matter which political party is in power,” Clark says. “That means it may make more sense to skip the deduction of a traditional IRA now to avoid tax later with a Roth IRA.”

Want to know how much money you can earn in your Roth IRA, you can use our Roth IRA growth calculator to run scenarios.