High-income earners may use a backdoor Roth IRA to work around tax rules that would otherwise prevent them from being able to have a Roth IRA and benefit from its tax-free growth potential. The backdoor Roth IRA strategy involves three basic steps: open or contribute to a traditional IRA, convert to a Roth IRA, and invest the funds. But IRS tax rules can make a backdoor Roth IRA more complicated.

How to do a backdoor Roth IRA conversion

The backdoor to a Roth IRA opens when an individual makes contributions to a traditional IRA (or rolls over funds from a 401(k) plan) then converts them to a Roth IRA. There are three steps to do this. 

1. Contribute to a traditional IRA with after-tax money. 

Typically, traditional IRAs are funded with pretax money. But in this case, the investor is making an after-tax contribution that is non-deductible and reported on IRS Form 8606. 

One can contribute up to $6,000 a year (or $7,000 for those over age 50) into an existing IRA or new IRA. If the contribution is kept in cash rather than invested, it is less likely to appreciate, which would incur additional taxes.

2. Convert funds in a traditional IRA to the Roth IRA. 

As soon as the funds are available in the traditional IRA, the investor may move them into a new or existing Roth IRA. In many cases, conversion can happen as quickly as the same or next day. The paperwork for this is relatively simple when the same company administers both accounts. An IRA administrator can provide guidance for other scenarios. 

Conversions are subject to taxation if deductible contributions were made to the traditional IRA or there were any capital gains on after-tax contributions before the conversion. After-tax contributions are not subject to additional taxes—but gains would be. 

3. Invest the converted Roth IRA funds

Now that funds have been deposited into the Roth IRA, Roth IRA assets can be invested to grow tax-free. The investor picks an investment that aligns with their retirement savings goals. When funds are withdrawn in retirement, there will be no tax. 

Tax implications of backdoor Roth IRA conversions

The IRS imposes extra taxes and penalties if the conversion process is not done correctly. A financial advisor or tax professional may be able to help answer any questions. These are some tax implications to keep in mind.

Even conversion of after-tax funds could be subject to taxes

Roth conversions are considered taxable distributions by the IRS. But determining how much tax could be owed on a conversion can be complicated when an investor has more than one IRA. To do this, the IRS aggregates, or totals together, contributions from all IRAs, and calculates taxes based on a percentage of the total that’s being converted. This is called the aggregation rule.

Imagine an investor already has a traditional IRA funded with $100,000 of pre-tax dollars, then opens a new IRA and makes a non-deductible (after-tax) contribution of $6,000, with plans to convert it to a Roth IRA. One might assume that no taxes would be owed on the conversion—since taxes have already been paid on that $6,000. However, the IRS views that $6,000 conversion as a 5.66% distribution on the $106,000 total, and the investor would owe income tax on $5,660. Take into consideration that the taxed money is considered income, and depending on circumstances, could increase your income and tax bracket.

The IRS does not aggregate 401(k) plans and 403(b) retirement savings plans, profit sharing plans, inherited IRAs, or a spouse’s IRA for a married filing jointly situation. This process can be rather complex, so it might be helpful to consult with a financial advisor or certified financial planner.

Contributions that appreciate before conversion are taxable

If the investor waits too long—more than a day or two before converting to a backdoor Roth IRA—the funds might appreciate, and gains could be taxable upon conversion. Two ways to avoid this:

1. Converting assets immediately from a traditional to a Roth IRA—on the same day or next— before assets have a chance to appreciate. 
2. Keeping assets in cash before performing the conversion.

Tax rules vary from state-to-state

Individual states in the U.S. treat backdoor Roth IRA conversions differently. Some have tax rules comparable to federal tax rules. Some states do not tax backdoor Roth IRA conversions. 

Rollovers from 401(k) plans into backdoor Roth IRAs might be taxable

Some investors may roll over funds from a traditional 401(k) into a traditional IRA and then convert to a Roth. A conversion like this could trigger a tax bill, however, because many traditional 401(k) plans are funded with pre-tax income. Roth IRAs must be funded with after-tax dollars. Once untaxed 401(k) funds are rolled over through the Roth backdoor, they become taxable. 

Considerations before doing a backdoor Roth IRA conversion

One can ask these questions before proceeding with a backdoor Roth IRA conversion. 

What’s your income level? 

For 2022, if your modified adjusted gross income (MAGI) is below $144,000 for an individual, or $214,000 for a couple filing jointly, you don’t need a backdoor Roth conversion. Just go through the “front door” and sign up for a Roth IRA directly. 

Keep in mind these phaseout ranges, which are the income cutoffs for tax benefits: $129,000 to $144,000 for individual single filers, or $204,000 to $214,000 for married couples filing jointly. If your MAGI is within the phaseout range, you can make a Roth IRA contribution, but it will be smaller than the maximum contribution limit.

Can you wait five years before taking money out? 

The IRS permits tax-free withdrawals of contributions to Roth IRAs. But for conversions to backdoor Roth IRAs, investors have to wait five years, starting from January 1 of the tax year they made the conversion. Otherwise, investors could be subject to additional income tax and potentially a 10% tax penalty on earnings withdrawals. 

Do you already have tax-deferred investments in a traditional IRA, SEP IRA, or SIMPLE IRA? 

Any money held in traditional, SEP, and SIMPLE IRAs is subject to taxes in the year the backdoor Roth IRA conversion is made. The IRS will apply the pro rata rule. 

In cases where the IRA balances don’t push you to a higher tax bracket, an investor may consider converting them and paying the tax bill in order to benefit from the Roth IRA’s tax-free growth.

The bottom line

Backdoor Roth conversions can be a savvy retirement planning solution for high-income earners hoping to benefit from the tax-free growth potential and less rigid distribution requirements of a Roth IRA. Despite its straightforward concept, the process can be rather complicated. 

The backdoor Roth IRA works by allowing high-income individuals to open a new (or contribute to an existing) IRA with the goal of converting it to a Roth IRA. If considering this option, keep in mind that there are tax implications, phaseout income ranges, and lock-in periods that could impact when you can access funds, how much you can contribute, and whether a conversion will trigger a tax bill. Because of the intricacies of the backdoor Roth IRA conversion process, it may be helpful for investors to consult with an expert like a tax professional.

FYI: Try Titan’s free Roth IRA Calculator to project how much your Roth IRA will give you in retirement.