Backdoor Roth IRA: What It Is, Tax Implications and How To Set One Up
A backdoor Roth IRA isn’t a specific type of individual retirement account. Rather, it’s a description of a strategy to help wealthier taxpayers avoid certain Roth IRA restrictions. Financial advisors are quick to note that despite being called “backdoor” Roths, there’s nothing shady about this strategy. In fact, IRS rules specifically allow it, although the IRS refers to it as a rollover or conversion.
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What Is a Backdoor Roth IRA?
As the name would suggest, a backdoor Roth IRA is a way to get money into a Roth IRA that wouldn’t normally be authorized. Since a Roth IRA provides great tax advantages in retirement, particularly for wealthy individuals, it’s perhaps not surprising that investors have exploited a loophole in the law that allows backdoor contributions.
How Does a Backdoor Roth IRA Work?
The “backdoor” in a backdoor Roth IRA is a traditional IRA. The strategy entails contributing to a traditional IRA and then moving some or all of those contributions into a Roth IRA to leverage the Roth’s tax advantages.
Why not just contribute directly to a Roth IRA? Many people do, but Congress has put in place income limits that prohibit wealthier individuals from contributing to them.
Currently, wealthier taxpayers can work around the Roth IRA income limits by instead making contributions to a traditional IRA. Since there are no income limits on contributions to a traditional IRA, higher-income taxpayers are free to contribute to an IRA up to the annual limit. Then, they can convert their traditional IRAs into Roth IRAs, thus providing “backdoor” access to a Roth.
For example, let’s say you earn $300,000 in modified adjusted gross income. The IRS won’t allow you to contribute to a Roth IRA, but you can put up to $6,500 into a traditional IRA for tax year 2023 ($7,000 for 2024). Later, you can convert that $6,500 to a Roth IRA. This essentially makes the traditional IRA a funnel into your Roth IRA, allowing you to backdoor the Roth income contribution limit.
Taxpayers looking to maximize the amount they can convert to a backdoor Roth IRA could contribute to a 401(k) plan that allows Roth IRA conversions. As 401(k) plans have a higher annual contribution limit — $20,500 for tax year 2023 ($23,000 for 2024) — it’s a quicker way to build up backdoor Roth IRA balances.
Is a Backdoor Roth Allowed for Tax Year 2023?
Yes. As of April 2024, backdoor Roths are still allowed for tax year 2023. However, investment brokerages warn that Congress has considered doing away with them. Schwab noted in a 2023 blog post that if the IRS closes the loophole without grandfathering in taxpayers who already made the conversation, the result could be a 6% excise tax, and perhaps a penalty, for overfunding the Roth account.
What’s the Difference Between a Roth IRA and a Backdoor Roth IRA?
There’s no difference between a Roth IRA and a backdoor Roth IRA. It’s the same account. The difference is in how you make contributions to the account.
Roth IRA contributions come from after-tax income. Backdoor Roth IRA contributions often come from a pretax traditional IRA or 401(k) account — the funds are converted to a Roth IRA.
Who Is Eligible for a Backdoor Roth IRA?
Specifically, for tax year 2023, if you’re married and filing jointly and have a MAGI less than $228,000 ($240,000 for 2024), you’re allowed to make contributions to a Roth IRA. Contributions phase out between incomes of $218,000 and $228,000 ($230,000 and $240,000 for 2024), with full contributions allowed for incomes under $218,000 ($230,000 for 2024). That limit drops to $153,000 ($161,000 for 2024) if you file as single, head of household or married filing separately and you did not live with your spouse at all during the year. The phaseout for these categories of filers ranges from $138,000 to $153,000 ($146,000 to $161,000 for 2024).
If you did live with your spouse at any time during the year and are filing separately, the contribution limit drops all the way to $10,000, with incomes between $0 and $10,000 experiencing a phaseout.
What Are the Benefits of a Backdoor Roth IRA?
The major advantage of a backdoor Roth IRA is that it lets you contribute to a Roth IRA even if your income is higher than the IRS allows. And the benefit of that is tax-free income in retirement.
The traditional IRA and/or 401(k) funds you convert to a Roth IRA are tax-deferred, meaning that you deduct the contributions on your tax returns, and the money grows tax-deferred until you withdraw it. Without the conversion, however, you’d pay tax on both your contributions and on the growth when you withdraw money in retirement. Because Roth IRA contributions are from after-tax income, you withdraw both your contributions and the growth tax-free. That can provide a considerable tax advantage, especially if you save for many years and enjoy many years of compound gains.
Another benefit of a backdoor IRA is that it eliminates the need for you to take required minimum distributions. With a traditional IRA, you must begin taking RMDs at age 73. Roth IRAs have no such requirement, so you can let your account continue to grow for as long as you want.
Investors also like backdoor IRAs for estate planning. As long as you’ve had the funds in your account for at least five years, your heirs can inherit the account tax-free. However, they will have to take RMDs from the account.
What Are the Downsides of a Backdoor Roth IRA?
There are two main drawbacks to creating a backdoor Roth IRA.
Taxes at the Time You Convert
First, any pretax contributions you convert to a Roth IRA are fully taxable at the time of conversion. This applies to any earnings on these contributions as well.
Funds Must Sit for 5 Years
The second drawback to a backdoor Roth IRA is that you cannot access money converted to a Roth IRA for a full five years after the date of the conversion without facing a 10% early distribution penalty. However, many wealthier taxpayers find these small prices to pay in exchange for the lifelong tax-free benefits of a Roth IRA.
Of course, the way for taxpayers to avoid income tax on backdoor Roth conversions is to make after-tax contributions to a traditional IRA or 401(k) plan. Then, the only taxes due on conversion are on the earnings attached to those contributions.
What Are the Tax Implications of Using a Backdoor Roth IRA?
While the ultimate goal of a backdoor Roth IRA is to generate tax-free income in retirement, the consequence usually is that you’ll have to pay taxes on the traditional IRA funds you convert, in the year you do the conversion.
Say, for example, you have $15,000 in a traditional IRA, $12,000 of which is your contributions and $3,000 of which is earnings on your contributions. You’ll have to pay tax on $15,000 when you convert the funds to a Roth IRA. That tax makes up for the $12,000 deduction you took on your original contributions and the deferred taxes on $3,000 in earnings. Once you’ve paid the tax, those funds are after-tax funds, just like you’d use to fund a Roth if your income was within the IRS limits.
The conversion gets complicated if you have more than one traditional IRA and/or you’ve made after-tax (nondeductible) contributions to a traditional IRA. Come tax time, you can’t simply report the amount you converted. You have to report your total balances, deductible and nondeductible, from all your IRAs. Then you calculate the percentage of the total assets that comprise the conversion. Then you figure out how much of that is taxable and how much is tax-free.
The term for this is IRA aggregation, which means that the IRS treats all of your accounts as a single account for tax purposes. Here’s an example of what it looks like in practice.
If you have two IRAs, one with $10,000 in deductible contributions and one with $40,000 in deductible contributions, and you want to convert the $10,000 account to a Roth IRA, you’d take the following steps:
Figure out what percentage of the total $50,000 is being converted:
$10,000 ÷ $50,000 = 0.20, or 20%
Calculate 20% of $10,000 to see how much of the $10,000 is tax-free:
$10,000 x 20% = $2,000 tax-free
Subtract the tax-free amount from the amount converted to calculate the taxable amount:
$10,000 – $2,000 = $8,000 taxable
Aggregation lets you do the same calculations no matter what the situation — converting part of a traditional IRA, for example, or converting one or more IRAs with both deductible and nondeductible contributions. That’s because you always start with the total of all of your IRA balances, and you always calculate the percentage that came from deductible contributions.
How To Convert a Traditional IRA to a Backdoor Roth IRA
If you already have a traditional IRA, converting the funds to a backdoor Roth IRA is easy. However, it’s a good idea to consult with a tax accountant or financial planning professional before you move the money. That way, you’ll understand the tax consequences and can prepare for the tax bill.
Open a Roth IRA at the brokerage where you have the traditional IRA.
Contact the brokerage to let it know you want to roll your traditional IRA into the new Roth IRA.
If you don’t already have a traditional IRA, you’ll have to take an extra couple of steps, but you can avoid the tax consequences. Again, consult with a financial professional to make sure this strategy is a good fit for you.
Open a traditional IRA with an investment brokerage.
Fund the IRA with one or more nondeductible contributions. The contributions become nondeductible when you file IRS Form 8606 with your tax return, according to Vanguard.
Open a Roth IRA with the same brokerage.
Contact the brokerage to let it know you want to roll your traditional IRA into the Roth IRA.
How To Convert a 401(k) to a Backdoor Roth
Some 401(k) plans allow participants to convert 401(k) contributions to a backdoor Roth. However, the plan must allow you to make after-tax contributions, according to Fidelity. In addition, the plan must have a Roth 401(k) that allows in-plan Roth conversions and/or allow in-service withdrawals of after-tax contributions. In-service withdrawals are withdrawals you make while still employed at the company offering the plan.
Alternatively, you might be able to roll your 401(k) into a Roth IRA, or roll your 401(k) into a traditional IRA, and then convert the traditional IRA to a Roth.
Contact your plan’s administrator to find out if your plan allows these so-called “mega” backdoor Roth conversions.
Is a Backdoor Roth IRA the Right Choice for You?
A backdoor Roth IRA could be the right choice for you if you’d like to take advantage of the tax benefits of a Roth IRA, but high income disqualifies you from contributing to one directly. This strategy can also factor into your estate planning because heirs can inherit the account tax-free.
It’s important to remember the consequences before you convert funds, however. You’ll have to pay tax on deductible traditional IRA contributions you convert. As taxable income, the converted funds could even bump you up into a higher tax bracket. In addition, you’ll have to wait at least five years to withdraw the money from the Roth account or else incur a penalty.
If any of these situations outweigh the long-term benefits of a conversion, you’re probably best off exploring other options.
John Csiszar contributed to the reporting for this article.
This article originally appeared on GOBankingRates.com: Backdoor Roth IRA: What It Is, Tax Implications and How To Set One Up
