What is a backdoor Roth IRA?
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“Verified by an expert” means that this article has been thoroughly reviewed and evaluated for accuracy.
BLUEPRINT
Published 11:20 a.m. UTC Nov. 30, 2023
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Key points
- A backdoor Roth IRA allows high earners to fund a Roth IRA despite income limits.
- The strategy involves making a nondeductible contribution to a traditional IRA and then converting it to a Roth IRA.
- In 2024, you can contribute up to $7,000 — or $8,000 if you’re 50 or older — to an IRA.
Roth individual retirement accounts, or Roth IRAs, are powerful retirement savings vehicles.
Unlike with traditional IRAs, you can’t take a tax deduction for contributions to Roth IRAs. But a major benefit is you get to withdraw your money tax-free in retirement. That means all the earnings you accrue between now and then won’t be taxed.
Unfortunately, Roth IRAs aren’t available to everyone. If you exceed income thresholds, you’re not allowed to contribute directly to a Roth IRA. While the front door is barred, you may still be able to get in by using a backdoor Roth IRA.
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What is a backdoor Roth IRA?
“A backdoor Roth IRA is a strategy utilized by high-income earners to make Roth contributions that otherwise would be disallowed because they exceed income limits to make contributions,” said Brian Ream, managing principal at CliftonLarsonAllen.
In 2024, those income phaseouts begin at $146,000 for individual filers and $230,000 for married folks filing jointly. Individuals who earn $161,000 or more and joint filers who earn $240,000 or more cannot contribute to a Roth IRA at all.
Through a backdoor Roth IRA, individuals who earn above those thresholds can convert traditional IRA funds into a Roth IRA, thus benefiting from a Roth’s tax-free growth.
How a backdoor Roth IRA works
To understand how a backdoor Roth IRA works, Ream said to start by looking at the problem it solves. High earners are ineligible to make direct Roth IRA contributions, and if they have access to a workplace retirement plan such as a 401(k), they can’t deduct contributions to a traditional IRA if they earn $87,000 or more as single filers or $143,000 or more as married joint filers. They can, however, make nondeductible contributions to a traditional IRA.
A nondeductible traditional IRA contribution is one you cannot deduct on your tax return. You have to pay taxes on the funds going into the traditional IRA, but earnings grow tax-deferred.
The emphasis above lies on tax-deferred, which is not the same as tax-free. If you make a nondeductible contribution to a traditional IRA, you will pay taxes on the earnings when you withdraw them, although the amount you contributed can be withdrawn tax-free. This is not quite as sweet of a deal as a Roth IRA, where both the earnings and your contributions can be withdrawn tax-free.
To get around the income limits of a Roth IRA and benefit from the tax-free growth, some individuals make nondeductible contributions to a traditional IRA and then convert it to a Roth IRA.
Here are the steps to do a backdoor Roth IRA:
- Make a nondeductible contribution to a traditional IRA.
- Convert that money to a Roth IRA.
You can also do a backdoor Roth IRA using pretax contributions you made to a traditional IRA, but this would add a third step where you pay taxes on the money before it enters the Roth IRA. After that, you’re tax-free.
How to set up a backdoor Roth
Setting up a backdoor Roth is fairly straightforward. Here are the steps:
1. Open a traditional IRA
You can use a traditional IRA you already have, although opening a new account makes tracking any tax consequences easier.
“While you can use a preexisting traditional IRA account, it’s important to note that if there is a current balance associated with the account, it will ultimately impact the total amount owed in taxes,” said Judi Leahy, senior wealth advisor for Citi Personal Wealth Management.
2. Make a nondeductible contribution to your traditional IRA
In 2024, you can contribute up to $7,000 — or $8,000 if you’re 50 or older — to IRAs. This amount is cumulative, meaning you can contribute up to the annual limit across all your IRAs. If you’re under 50 and have already contributed $1,000 to another IRA, for example, then you can put in only $6,000 for your backdoor Roth.
Remember that since the contribution is nondeductible, you can’t write it off on your taxes. Instead, you’ll need to file IRS Form 8606 to report the contribution so the IRS knows it already got its share of the money.
3. Convert the traditional IRA to a Roth IRA
If you don’t have one, now is the time to open a Roth IRA. The conversion process can be done seamlessly by opening the account with the same account provider or broker that opened your traditional IRA, Leahy said.
Once your Roth is open, you can convert the after-tax money you put in your traditional IRA to your Roth IRA. You want to do this conversion as soon as possible to minimize the chance that earnings accrue in the traditional IRA, Leahy said. As long as no earnings are moved with the nondeductible contribution, there should be no tax implications in the current year.
If you used pretax dollars in the conversion — that is, if you took a tax deduction for your traditional IRA contribution before converting it to a Roth IRA — you will need to pay taxes on that money.
Who should do a backdoor Roth IRA?
“Any individual whose current income exceeds the contribution limits should consider the strategy,” Ream said of the backdoor Roth IRA. “More specifically, investors seeking retirement distributions that would be income tax-free could explore the strategy with their CPA and wealth advisor.”
The key benefits of a Roth IRA are the tax-free growth and tax-free distributions in retirement, he said. When you withdraw from a traditional retirement account that was funded with pretax dollars, you’ll need to pay income taxes on that amount. Having after-tax savings in a Roth can help you pay less taxes in retirement.
Managing taxes becomes particularly challenging when you need to start required minimum distributions, or RMDs.
“These required distributions, now beginning at age 73, can thrust a retiree into a higher tax bracket,” Ream said.
But Roth savings are not subject to RMDs unless they are inherited because the IRS took its cut before the money went into the account.
“When considering a backdoor Roth IRA, it’s important to be mindful of the time frame in which you plan to access the funds, as penalties can be issued when withdrawing within five years of the Roth IRA conversion,” Leahy noted.
Leahy also emphasized the importance of consulting a financial advisor before making a backdoor Roth IRA conversion.
“Ensure you’re abiding by regulations instilled by the IRS and minimizing tax implications that can arise from the conversion if not completed correctly,” she said.
Backdoor Roth IRA alternatives
There aren’t any strategies that can top a Roth IRA in terms of tax advantages, but some alternatives could provide similar benefits, which we explain below.
After-tax contributions to a traditional IRA
This is essentially completing the first and second steps of the backdoor Roth IRA process detailed above. In this case, only your earnings would be taxed upon withdrawal.
“Since the contributions were not deductible, they are not taxed again at distribution,” Ream said. “You could look at that as a hybrid of traditional retirement accounts and Roth retirement accounts.”
Taxable accounts
There’s nothing special about this strategy. Simply put money into a taxable brokerage account and invest it as you would your IRA savings. You can’t take a deduction for money you put into the account, and you will need to pay annual taxes on any income and gains from sales earned throughout the year, but you won’t owe taxes when you withdraw it.
“While investing in a taxable account won’t offer the same tax benefits as a backdoor Roth IRA, it can result in a lower tax bill and give you the opportunity to diversify your investments,” Leahy said.
Frequently asked questions (FAQs)
You won’t pay taxes on a backdoor Roth if you convert a nondeductible contribution to a traditional IRA to a Roth IRA before it begins to accumulate earnings. As long as you convert only after-tax money into the Roth, you won’t owe any taxes on the backdoor conversion.
Anyone can do a backdoor Roth IRA by converting money from a traditional IRA to a Roth IRA, even if you have a 401(k). If you want to convert money from a 401(k) to a Roth IRA, the process is called a mega backdoor Roth, which has a few additional requirements. Namely, your 401(k) plan must allow after-tax contributions and in-service withdrawals.
Roth IRA conversions require a five-year holding period before you can withdraw the funds; otherwise, you may have to pay a 10% penalty. Remember that the five-year rule applies to each conversion you make.
Backdoor Roth IRAs and regular Roth conversions have an important distinction.
With a regular Roth conversion, you transfer money that was originally deducted from your income for tax purposes. As a result, you must pay taxes on the converted amount.
But a backdoor Roth IRA converts a contribution made with after-tax dollars. Therefore, the conversion is not a taxable event.
For some high earners, a backdoor Roth IRA may be the only way to access the tax advantages of a Roth account.
But these accounts may not be right for everyone. Most notably, anyone who expects to need the money within five years should consider saving elsewhere to avoid violating the five-year rule. Speak to a finance professional to determine the best savings strategy for you.
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