A backdoor Roth IRA strategy could be useful to high earners as they may not be able to fully deduct IRA contributions, and they may not be able to contribute directly to a Roth IRA—i.e., via the “front door”—due to income limits on contributing.
What is a Backdoor Roth IRA?
A backdoor Roth IRA is a strategy that allows high-income earners to contribute to a Roth IRA even if their income exceeds the IRS limits for direct Roth IRA contributions. It involves making a non-deductible contribution to a traditional IRA and then converting that contribution to a Roth IRA.
How Does a Backdoor Roth IRA Work?
- Make a non-deductible contribution to a traditional IRA. There are no income limits for making non-deductible contributions to traditional IRAs.
- Convert the non-deductible contribution to a Roth IRA. This is where the “backdoor” comes in. You can convert the entire traditional IRA balance, including any earnings, to a Roth IRA.
- Pay taxes on any earnings. If the traditional IRA has any earnings, you will need to pay taxes on those earnings when you convert them to a Roth IRA.
Is a Backdoor Roth IRA Right for You?
There are several factors to consider when deciding whether a backdoor Roth IRA is right for you:
- Your income: Backdoor Roth IRAs are only available to high-income earners who are unable to contribute directly to a Roth IRA.
- Your tax bracket: If you are in a high tax bracket now, it may make more sense to keep your money in a traditional IRA and pay taxes on it when you withdraw it in retirement.
- Your age: If you are close to retirement, you may not have enough time for the money in your Roth IRA to grow tax-free.
- Your risk tolerance: Backdoor Roth IRAs are subject to the same market risks as any other investment.
Pros and Cons of a Backdoor Roth IRA
Pros:
- Tax-free growth: The money in your Roth IRA will grow tax-free.
- Tax-free withdrawals: You can withdraw your contributions and earnings from your Roth IRA tax-free in retirement.
- No income limits: There are no income limits for making non-deductible contributions to a traditional IRA.
Cons:
- Taxes on earnings: You will need to pay taxes on any earnings when you convert the traditional IRA to a Roth IRA.
- Pro rata rule: If you have other traditional IRA assets, you may need to pay taxes on a portion of the conversion.
- Complexity: Backdoor Roth IRAs can be complex and may require the assistance of a financial advisor.
How to Get Started with a Backdoor Roth IRA
If you are considering a backdoor Roth IRA, it is important to talk to a financial advisor to make sure it is the right strategy for you. They can help you understand the risks and benefits involved and can help you set up the conversion.
Here are some additional things to keep in mind:
- Make sure your traditional IRA is eligible for a conversion. Not all traditional IRAs are eligible for conversion to a Roth IRA.
- Choose the right Roth IRA. You can convert your traditional IRA to any Roth IRA.
- Report the conversion on your tax return. You will need to report the conversion on your Form 1040.
A backdoor Roth IRA can be a valuable tool for high-income earners who want to save for retirement in a tax-advantaged way. However, it is important to carefully consider the pros and cons before deciding if it is right for you.
Key considerations for a backdoor Roth IRA
Before performing a backdoor Roth IRA, keep the following points in mind:
Are backdoor Roth IRAs allowed in 2022? The Build Back Better Act would have ended backdoor Roth IRAs starting in 2022. With this legislation currently on the backburner, however, the strategy remains alive and well, at least for now.3
What are the tax ramifications of a backdoor Roth IRA? In certain cases, a backdoor Roth IRA may require you to pay taxes. These include:
If you opted to convert your traditional IRA to a Roth IRA after deducting your traditional IRA contributions, you will be responsible for paying taxes on the pretax assets. Be ready to pay income tax on the pretax money you converted to a Roth when it comes time to file your taxes. Should you have any additional pretax IRA assets after your backdoor conversion This is known as the pro rata rule.
The pro rata rule: One of the most important rules relevant to the backdoor Roth conversion is the pro rata rule. This is an IRS rule4 that determines what amount is subject (or not) to taxes when you convert IRA dollars from a traditional IRA to a Roth IRA. To put it simply, if you attempt to convert after-tax traditional IRA contributions to a Roth IRA, but there are existing pretax IRA dollars, you will be subject to taxation on a prorated basis.
Your total IRA accounts will be considered by the IRS when calculating your tax liability on a conversion from a traditional to a Roth IRA. For instance, if the total amount in all of your IRAs is 80% pretax and 2020 after-tax money, the percentage of the after-tax money that you convert to a Roth will be taxable based on the 80/20 ratio.
For this particular example, 80% of the amount you convert to the Roth will be taxable regardless of how much money you convert or which pretax IRA account you withdraw the money from. The pro rata rule is applied by the IRS to your entire IRA balance at year-end, not when you convert.
The five-year rule states that earnings or converted IRA funds cannot be taken out of an account tax-free for five years after they are deposited. You have to be at least 59½ years old and have owned the account for at least five tax years in order to withdraw money from a Roth IRA without incurring taxes or penalties. If money is taken out before the agreed upon time, you might have to pay taxes on any earnings and possibly face a 2010% penalty unless you are older than or equal to the C2%BD percentage.
Transfers involving backdoor Roth IRAs: Remember that the conversion must fit into one of these categories:
- a rollover, in which you obtain money from your IRA and, within 60 days, transfer it to a Roth account
- a trustee-to-trustee transfer, where your money is sent straight from the IRA provider to the Roth IRA provider
- When an IRA is transferred using the “same trustee,” the traditional and Roth IRAs are held by the same financial institution.
Is a backdoor Roth IRA worth it?
The backdoor Roth conversion may not be suitable for everyone’s financial objectives and strategies, depending on a number of variables. For example:
1. If you are able to reach your savings targets with the maximum retirement limit through your workplace retirement account and do not anticipate needing to make additional savings, you might not require a backdoor Roth conversion.
2. The pro rata rule means that if you already have pretax money in a traditional IRA, converting may not be beneficial from a tax standpoint.
3. It’s important to remember that the pro rata computation does not account for inherited IRAs.
4. Before taking any withdrawals, you should be prepared to maintain the money in the recently established Roth IRA for a minimum of five years.
5. If you are currently in a high tax bracket and anticipate being in a lower tax bracket when you retire, you might want to keep the money in the traditional IRA.
6. If you intend to move to a state with no income taxes or one with a lower income tax
However, you might want to think about a backdoor Roth conversion if:
1. You’ve already maxed out other retirement savings options.
2. You are a high-income earner.
3. You intend to keep the funds in the Roth for a minimum of five years, if not longer.
4. You do not have other Roth assets.
12 Things You Must Know About A Backdoor Roth IRA (Including If It’s Worth The Hassle)
FAQ
Is backdoor Roth worth it high income?
What is the 5 year rule for backdoor Roth IRAs?
What is the downside of Roth conversion?
Is backdoor Roth still allowed in 2024?
Can you do a backdoor Roth IRA?
If your IRA provider won’t manage the transfer of funds and hands you a check, you can still do a backdoor Roth IRA. But you must deposit the check in a new Roth IRA account within 60 days. Otherwise, it may be considered an early withdrawal, with potential taxes and penalties. Immediately convert your new traditional IRA to a Roth IRA.
What is a backdoor Roth IRA strategy?
The backdoor Roth IRA strategy is also beneficial for someone who anticipates having funds leftover in their traditional IRA because they can pass the money on to their heirs in a Roth IRA. A Roth IRA allows taxpayers to set aside a few thousand dollars from their annual earnings in a retirement savings account.
What is the difference between a Roth IRA and a backdoor IRA?
The difference is the way you make your contribution. High-income earners use the backdoor technique to establish a Roth IRA since they’re unable to contribute in the standard way because of the Roth IRA income limits. Do you pay taxes on backdoor Roth IRAs? Are backdoor Roth IRAs worth it? How much can I contribute?
Should high earners consider a backdoor Roth IRA strategy?
A backdoor Roth IRA strategy could be useful to high earners as they may not be able to fully deduct IRA contributions, and they may not be able to contribute directly to a Roth IRA—i.e., via the “front door”—due to income limits on contributing.