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What Exactly Is a Backdoor Roth IRA?

June 1, 2022
7
min

The backdoor Roth IRA is a type of retirement savings vehicle, although it is a process more complicated than it would at first appear. Learn more about how it works.

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Those who make after-tax investments in a Roth IRA can see decades of tax-free growth and retirement income that won’t be taxed. However, high-income individuals earn too much money to open—or contribute to—a Roth. The backdoor Roth IRA is a workaround that takes a  traditional IRA and converts it to a Roth IRA.

The backdoor Roth IRA is not a new type of IRA. It’s actually been around since 2010, when the U.S. Congress lifted the $100,000 income limit on IRA conversions.

What is a backdoor Roth IRA?

A backdoor Roth IRA is a type of retirement savings vehicle that allows high-income individuals to access a Roth IRA, which they normally wouldn’t be allowed to do because of income limits set by the IRS. This legal loophole enables high-earners to open a traditional IRA, make contributions, then immediately convert the account to a Roth IRA. 

Why would an investor consider doing a backdoor Roth IRA conversion? 

Both traditional IRAs and Roth IRAs offer tax benefits to investors saving for retirement, but they have key differences. For instance, a traditional IRA front-loads its tax breaks, meaning that investors may take an upfront deduction on their income taxes and then are taxed later when they take distributions, typically in retirement. Contributions are tax deductible under certain conditions, depending on employer retirement plan coverage, taxpayer filing status, and income level.

By comparison, the Roth IRA doesn’t provide tax breaks upfront. You make contributions to a Roth on an after-tax basis—up to $6,000 per year ($7,000 for individuals over age 50). Contributions can come from monthly bank transfers, payroll deductions, and annual lump sums. Unlike the traditional IRA, Roth IRA assets grow tax-free, and withdrawals after retirement are not subject to income tax.

High-income earners who want to open a Roth IRA face significant barriers to entry, though. 

  • Individuals with modified adjusted gross income (MAGI) between $129,000 and $144,000 for single filers, $204,000 to $214,000 for married filing jointly, or $0 to $10,000 for married filing separately, face limitations on how much they can contribute to a Roth. The IRS calls these limits income phase-out ranges
  • Above the income ceilings of $144,000 (single filer) and $214,000 (married filing jointly), individual investors cannot make any contributions. Essentially, high- income earners are “locked out” of the Roth IRA house.

However, there are no income limits on who is eligible to do an IRA conversion. This is where the backdoor to a Roth opens: An investor makes contributions to a traditional IRA that is not subject to income ceilings, then converts it into a Roth IRA. It’s a loophole that’s legal, for now, but its future is questionable.

How a backdoor Roth IRA works

The key to the backdoor Roth IRA strategy is converting, meaning taking contributions made to a traditional IRA and switching them to a Roth IRA. To convert IRA to Roth:

  • Open a new traditional IRA
  • Make a non-deductible contribution—preferably as a lump sum to potentially avoid or minimize taxes from capital gains—up to $6,000 ($7,000 over 50 years old) and leave the money in cash via a money market fund or settlement fund. 
  • Because the contributions aren’t being deducted on taxes, there are no income restrictions on them. Non-deductible contributions must be listed in IRS Form 8606.
  • Immediately convert your traditional IRA to a Roth IRA.

Additional backdoor Roth IRA strategies include:

  • The mega backdoor Roth. This different and complex approach lets an investor roll over after tax dollars (up to $45,000) from a traditional 401(k) into a Roth IRA or Roth 401(k) plan. It requires enrollment in an employer-sponsored traditional 401(k) plan that allows after-tax contributions. The plan also must permit the ability to make in-service withdrawals that let you take out money while still employed at the company, or shift funds from the after-tax balance in the traditional 401(k) plan into the Roth 401(k) plan. 
  • Tax deductible contributions. Alternatively, an investor could use pre-tax dollars to make tax deductible contributions to a traditional IRA or a traditional 401(k), then convert them into the Roth IRA. Keep in mind: taxes will likely be owed on such conversions because the traditional IRA contributions were tax deferred. 

High-income earners with a Simplified Employee Pension individual retirement accounts (SEP IRAs) or Savings Incentive Match Plan for Employees individual retirement accounts (SIMPLE IRAs) are eligible to do backdoor Roth IRA conversions, too. The strategy may be worth considering if expecting to be in a higher tax bracket upon retirement. 

  • The rules applying to SEP IRAs are similar to traditional IRAs. Income taxes will be owed on the balance converted to Roth.
  • The SIMPLE IRA must be held for at least two years before conversion to avoid a 25% penalty. Taxes will be owed on the converted balance.
Side note: Try Titan’s free Roth IRA Calculator to project how much your Roth IRA will give you in retirement.

Tax implications of backdoor Roth conversions

Typically, if the contribution to the traditional IRA is made as a lump sum and immediately converted to a Roth IRA, tax bill risks are likely to be minimal. But there are complicating factors with respect to taxes and conversion rules to consider. 

Aggregation and pro rata rules. The IRS treats backdoor Roth IRA conversions as income, and if the investor has one or more traditional IRAs already with sizable assets, the conversion could push the investor into a higher tax bracket for that year. 

  • The IRS sees funds going into any of your IRAs in the aggregate. This means that tax-deferred and after-tax contributions are totaled together, as if one big pie. 
  • Say a traditional IRA already exists from a rollover and it was never taxed, and you open a new traditional IRA for the purpose of conversion to a backdoor Roth IRA. The taxes owed upon conversion depend on the ratio of untaxed IRA assets to already-taxed IRA assets. This is called the pro rata rule. If untaxed rollover IRA assets swamp the after-tax contributions to the new IRA, the new IRA’s assets will be taken into consideration for tax purposes upon conversion.
  • The aggregation rule does not apply to retirement plans like 401(k)s, 403(b)s, profit sharing plans, or inherited IRAs. For a married filing jointly tax return, a spouse’s IRA would not be aggregated, because tax bill calculations for IRAs are made on an individual basis.

Five-year rules. The Roth IRA permits the withdrawal of contributions any time at any age, with some exceptions. But there are two questions to consider before being able to withdraw contributions plus earnings, penalty-free: 

  1. Have you reached age 59 ½? 
  2. Has the Roth IRA existed for 5 years or more? 

If the answer to either is “No,” then in this situation the two necessary criteria have not been met to withdraw without penalty. 

Another five-year rule applies directly to backdoor Roth IRA conversions, which are distinct from contributions. Converted funds must stay in the Roth IRA at least five years before they can be withdrawn penalty-free. The five-year clock starts each and every time a backdoor Roth IRA conversion occurs (with some exceptions based on age, disability, or death).

Tax implications on gains before conversion. If an investor opens a traditional IRA for the purpose of converting it, but allows time to pass between funding and converting the account, then taxes might be owed on any appreciated assets before the conversion. Investors might consider a workaround such as placing the traditional IRA funds in an investment vehicle like cash in a mutual fund that is unlikely to appreciate much, and then perform the backdoor Roth IRA conversion immediately.

State and federal tax implications. States vary on how they treat a backdoor Roth IRA conversion from a traditional IRA. Some states mimic federal tax rules. Some exempt taxes on part of a pension or IRA distribution if the individual exceeds a certain age. And some won’t tax the backdoor conversion at all. But a conversion could also open the door to federal taxes and penalties, so an investor might want to consider discussing with a tax professional.

401(k) rollover considerations. It is possible to rollover a traditional 401(k) into a backdoor Roth IRA, but it is likely that income tax will be owed upon conversion (because a traditional 401(k) is funded with pre-tax income and Roth IRAs are funded with after-tax dollars). When the rollover occurs, the 401(k) funds become taxable. 

The bottom line

Backdoor Roth conversions allow high-income individuals to reap the benefits of a Roth IRA that would typically be out of reach. It’s a clever strategy used to remove the income restrictions barring high earners from contributing to a Roth IRA.

The backdoor Roth IRA process is more complicated than it would at first appear. Several critical factors—income level, federal and state tax laws, and conversion rules—can help individual investors determine whether a backdoor Roth is a worthwhile option. Consider discussing backdoor Roth IRAs with a tax professional or financial advisor to help sift through the intricacies of a conversion and tax ramifications of this retirement investment strategy.

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