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Backdoor Roth IRAs

Background on IRAs

This post explores a next-level method of funding a Roth IRA. For first-level information on IRAs and a discussion on the relative merits of Roth vs. Traditional IRAs, see this post.

What is a Backdoor Roth IRA?

A backdoor Roth IRA is a method of contributing to a Roth IRA if you are unable to make direct contributions to a Roth IRA due to exceeding income limits.

Direct Roth IRA contributions are limited based on income. In 2022, if your modified adjusted gross income (MAGI) is above $129,000 for single tax filers or $204,000 for married filing jointly tax filers, then you are limited or entirely disallowed from contributing directly to a Roth IRA.

Roth IRA Income Limits 2022

While Roth IRA contributions are restricted based on income, Roth conversions are not. And a Roth conversion is what you are actually performing through a “backdoor Roth IRA.”

The term “backdoor Roth IRA” is essentially a slang term for the process of making a nondeductible contribution to a Traditional IRA and immediately converting it to a Roth IRA. (You won’t find “backdoor Roth” on the IRS’ website.)

Why might you consider a Backdoor Roth IRA?

Exploring backdoor Roth IRAs will generally start when your income approaches the income limits to contribute directly to a Roth IRA.

Two common scenarios where a backdoor Roth begins to make sense are:

1. Your income exceeds the Roth IRA income limits

The most obvious reason you may explore a backdoor Roth IRA is your income exceeds the limits to make a direct (front door) Roth contribution.

2. You want to make a Traditional IRA contribution, but your income exceeds the limits to take a tax deduction

Similar to restrictions on direct Roth IRA contributions, the deductibility of Traditional IRA contributions is also subject to income limits. And if you can't make a direct Roth contribution, then you are likely also restricted from making deductible Traditional IRA contributions.

Tax-deductible contributions to IRAs are limited by (1) income and (2) whether you or your spouse are covered by an employer-provided retirement plan (ex: 401(k)).

If you or your spouse are covered by a retirement plan at work, then your ability to make tax-deductible contributions is limited based on income. If neither of you is covered by a work-sponsored plan, you may make a tax-deductible IRA contribution.

IRA Deductibility 2022

Assuming you are not allowed to make tax-deductible contributions, you could opt to make a nondeductible IRA contribution. This means you won’t get a tax break (deduction) for your contribution, but you can still contribute and benefit from tax-deferred gains in the IRA.

If you make nondeductible contributions to your IRA, when you make withdrawals in retirement only the earnings portion will be taxable. The nondeductible contributions will not be taxable (because you never got a tax break for these contributions in the first place).

Nondeductible IRA Taxes

If you are in a position where you can only make nondeductible IRA contributions, then you should absolutely consider a backdoor Roth IRA.

Why? When you make withdrawals from your Roth IRA in retirement, the entire withdrawal is tax-free. (As opposed to being subject to taxes on your earnings like in the example above.)

Nondeductible IRA Contributions vs. Backdoor Roth IRA Contributions

For example, let’s compare a $6,000 nondeductible IRA contribution vs. a $6,000 backdoor Roth IRA contribution. If both accounts grow by about 6% per year for 25 years, they would end up at $25,751.

For the nondeductible IRA, the earnings portion ($19,751) will be taxable upon withdrawal.

The Roth IRA will be entirely tax-free upon withdrawal.

Assuming a 20% tax rate, your nondeductible IRA would translate to $21,801 after tax, compared to the full $25,751 for your Roth IRA.

Nondeductible vs. Backdoor Roth IRA

This is why converting a nondeductible IRA contribution to Roth is a no-brainer, so long as it’s appropriate for your situation.

When is a Backdoor Roth IRA not appropriate?

Due to something called the “pro-rata rule,” maximizing the benefits of a Backdoor Roth IRA requires that you not have any other Traditional IRA assets. If you have Traditional IRA assets, the negative tax consequences tend to outweigh the benefits of the backdoor Roth.

What is the pro-rata rule?

The pro-rata rule applies to Roth conversions (the technical term for the action you are taking through a backdoor Roth IRA). The pro-rata rule states that taxable income will be recognized on any Roth conversions based on the pre-tax percentage of your Traditional IRAs.

For example, suppose you have a $94,000 Traditional IRA which you have funded with pre-tax contributions (or you may have rolled an old 401(k) into a Traditional IRA). If you make a $6,000 non-deductible IRA contribution and convert $6,000 to a Roth IRA, 94% ($6,000 * 94% = $5,640) of the conversion will be recognized as taxable income.

Pro-rata rule example

You cannot choose to only convert the nondeductible portion of your IRA. The conversion amount is broken down pro-rata according to your deductible and nondeductible contributions.

Backdoor Roth IRA Steps

Backdoor Roth IRAs take just a few steps and many custodians will help you with this process.

Backdoor Roth Step-by-step

1. Make a Nondeductible contribution to your Traditional IRA

A nondeductible contribution is a contribution to your Traditional IRA for which you do not claim a tax deduction.

Do not invest this contribution. The money will remain in this account temporarily before transferring it to your Roth IRA. (If you were to invest the money, any earnings would be taxable.)

2. Convert your Traditional IRA to your Roth IRA

Convert the entire balance that you deposited into your Traditional IRA to your Roth IRA.

3. Invest the funds after conversion

Invest the funds in your Roth IRA according to your objectives and risk tolerance.

Pitfalls to Avoid

The main pitfalls to avoid in performing a backdoor Roth IRA concern other Traditional IRA accounts and generating a tax bill.

1. You have Traditional IRA assets

As discussed above, if you already have Traditional IRA assets, your conversion will be subject to the pro-rata rule. This will lead to recognizing additional taxable income today and decrease the effectiveness of the backdoor Roth IRA strategy.

2. Rolling Over Assets into your Traditional IRA later in the year

If you perform a backdoor Roth IRA contribution early in the year and subsequently roll assets into a Traditional IRA before year-end, then you will be subject to the pro-rata rule.

The value of your Traditional IRA as of December 31st is the key date for performing backdoor Roth contributions. Even if you don’t have any Traditional IRA assets at the time of executing the backdoor Roth, if you have Traditional IRA assets at the end of the year then you will hamper the strategy's effectiveness.

3. Investing Funds in your Traditional IRA

There is no need to invest the funds when you deposit them in your Traditional IRA. The amount you contribute to the Traditional IRA should be quickly converted to a Roth IRA.

If you invest the funds in your Traditional IRA and convert the balance, the earnings portion will be treated as taxable income.

Legislative Risk to the Backdoor Roth IRA Strategy

The “backdoor Roth IRA” is often called out for potential legislative action. The strategy has been scrutinized since Roth conversions were made available to high-income earners in 2010.

However, although this “backdoor” strategy has a somewhat sinister name, it is a perfectly legal application of a Roth conversion. But should Congress prohibit Roth conversions in the future, the backdoor Roth IRA would likely go with it.