Backdoor Roth IRA: What It Is and How It Works

Before jumping into the Backdoor Roth IRA, it is important to understand how a standard Roth IRA works. A Roth IRA, or individual retirement account, is a type of investing account designed to help you save for retirement. The money that you put into a Roth IRA grows tax free and when you take the money out in retirement you do not have to pay any taxes.

The idea behind a Roth IRA is to pay taxes now, and then enjoy zero taxes in retirement when you pull the money out. When you contribute to a Roth IRA, you make contributions with dollars that you have already paid taxes on.

However, once those dollars are in your Roth IRA, they grow tax free and you can then withdraw the money tax free in retirement once a couple of rules have been met. The tax benefits make the Roth IRA a very attractive account to use for retirement.

Keep in mind that a Roth IRA is an investing account and not an investment itself. Instead a Roth IRA just holds all your investments. When you open a Roth IRA, you still must put investments within the account. Do not get caught up on what investments you should put in your Roth IRA. We will look at that later.

Since the Roth IRA offers tax benefits, the IRS has rules and qualifications you must follow or meet to open and use a Roth IRA.

Eligibility

Unfortunately not everyone can have a Roth IRA, which is when the Backdoor Roth IRA becomes an option. The first requirement you must meet is that you must have earned income - such as income from a job to open a Roth IRA. Secondly, your income can't exceed certain levels if you want to open and contribute to a Roth IRA.

If your tax filing status is single or head of household, your modified adjusted gross income (MAGI) has to be $146,000 per year or less to make the maximum contribution to a Roth IRA. If your income is between $146,000 and $161,000 you can contribute a reduced amount to a Roth IRA. However if your income is $161,000 or above, you can't use a Roth IRA at all.

If your tax filing status is married filing jointly or qualified widow(er), your modified adjusted gross income (MAGI) has to be $230,000 per year or less to make the maximum contribution to a Roth IRA. If your income is between $230,000 and $240,000 you can contribute a reduced amount to a Roth IRA. However if your income is $240,000 or above, you cannot use a Roth IRA at all.

Contribution limits

Additionally, the IRS also limits how much you can put into a Roth IRA on a yearly basis. The maximum amount you can contribute to a Roth IRA is $7,000 per year of $8,000 per year if you are 50 and older.

Using the eligibility rules above, you may be able to contribute a reduced amount if you don't qualify to contribute the full amount. You can use IRS rules to figure out what your reduced contribution amount would be.

Withdrawal rules

Finally, you must meet a couple of rules to withdraw money from your Roth IRA. First, the account must be at least 5 years old. Second, you must be 59 and a half years old. If you try to withdraw the money in your Roth IRA before meeting these rules, you can incur a 10% penalty and additional income taxes.

The exception to this rule is that you can withdraw your base contributions without incurring a penalty. For example, say that you had made the max contribution allowed to your Roth IRA, which would be $7,000 per year if were younger than 50. At any point, you could withdraw that money from your Roth IRA.

However, say that your original contribution of $7,000 had grown in value to $10,000 as the investments within your Roth IRA grew in value. If you tried to take out the $10,000, you could incur a 10% penalty and income taxes on the $3,000 your investments had earned in the account.

A Backdoor Roth IRA is a strategy that high income earners use if they do not qualify for a Roth IRA. A Backdoor Roth IRA allows individuals to convert a Traditional IRA into a Roth IRA when their income is too high to immediately use a Roth IRA.

For example, let's say that an individual that files their taxes under the single tax filing status makes above $161,000 per year. According to the Roth IRA rules (which we looked at above), this individual would not be able to make contributions to a Roth IRA as the IRS dictates their income is too high.

The Backdoor Roth IRA is a legal way for this person to get around the income limitations of a Roth IRA. It works using three steps.

Step 1 - The first step to a Backdoor Roth IRA is to open a Traditional IRA. You can place investments within this Traditional IRA and fund it up to the limit if you choose which is $7,000 per year or $8,000 per year if you are 50 or older.

Step 2 - Secondly, you need to convert your Traditional IRA contributions into a Roth IRA. If you do not have a Roth IRA, you will need to open one up. The company that holds your Traditional IRA can help you with the technical steps to complete this. You can also work with a financial advisor for more support if they offer it as a service.  

Step 3 - When you do a Backdoor Roth IRA, you can incur taxes depending upon the amount you transfer and if you made deductible contributions to your Traditional IRA. Be prepared to pay taxes. Once taxes are paid, the remaining money grows in your Backdoor Roth IRA tax free and you can then make withdrawals tax free in retirement if you are following the withdrawal rules.

You can do a Backdoor Roth IRA on a yearly basis, but there are also some other options. First, you can convert an entire Traditional IRA to a Roth IRA. This can trigger higher taxes, however. You can also roll your employer 401k plan over to a Roth IRA if allowed by your plan.

Backdoor Roth IRAs are taxed at the end of the year based upon a pro-rata rule. Let's think through this a bit. Remember, the money that ends up in a Backdoor Roth IRA started in a Traditional IRA. The IRS looks at how you treated that Traditional IRA before you do a Backdoor Roth IRA to determine taxes.

Due to the way the Traditional IRA works, there is the possibility to take a tax deduction when you put money into a Traditional IRA. The max deduction you can take is up to the contribution limit which is $7,000 per year or $8,000 per year if you are 50 or older.

If you take a tax deduction on the $7,000 you contribute to a Traditional IRA before doing a Backdoor Roth IRA, the entire $7,000 is taxable during the conversion. The IRS is saying that since you got a tax break when you held money in the Traditional IRA, you need to pay those taxes when you convert the money to a Roth IRA.

However, if you do not take a tax deduction on the $7,000 when you contributed to the Traditional IRA, you won't owe any taxes on the conversion. Additionally, you will owe taxes on any money that the investments within the Traditional IRA earned before you converted it to a Roth IRA.

For example, let's say that you contributed $7,000 to a Traditional IRA and left the money in the account for an entire year before doing a Backdoor Roth IRA. During that time, the value of the account grew by 20% or $1,400. When you do a Backdoor IRA, that $1,400 gain is subject to tax.

This is where the pro rata rule kicks in. Say that in the example above the $7,000 you contributed to the account was non-deductible meaning you did not take a tax break on it. This money would not be taxable during the Backdoor Roth IRA process, but the $3,000 gain would.

The IRS is looking at the taxable vs non-taxable money in the account. In this case 30% of the money that you convert is taxable. The IRS does not allow you to only convert non-deductible contributions to avoid taxes. Thirty percent of the money you convert would be taxable in this scenario regardless of the amount.

It is important to note the IRS uses this pro rata rule for all of the Traditional IRAs you might have. This means that if you have multiple IRAs, the IRS will look at the taxable vs non-taxable money across all IRAs when assessing taxes on the pro rata basis.

On the flipside, let's say that you did take a tax deduction on the $7,000 you contributed to the Traditional IRA. Both your contributions of $7,000 and gain of $3,000 are subject to taxes.

If you qualify for a standard Roth IRA, there is no need to use a Backdoor Roth IRA. The Backdoor Roth IRA exists to help high income earners get around the income limitations of the normal Roth IRA legally. The reason that individuals choose to do a Backdoor Roth IRA is to get the tax benefits of a Roth IRA.

The standard Roth IRA is funded with pre-tax dollars, but withdrawals are tax free in retirement as long as you follow the Roth IRA withdrawal rules. The Traditional IRA is a tax deferred account which means you won't owe any taxes until you pull the money out in retirement. For some investors, converting the tax deferred dollars in a Traditional IRA to the tax free dollars of a Roth IRA makes sense.

For example, lets say that you earn $165,000 per year and file your taxes under the single filing status which pushes you out of the income limitations for a normal Roth IRA. Depending upon where you live, this would put you in an effective tax rate of around 31%.

Let's assume that when you retire you want to keep your lifestyle the same and plan on needing $165,000 of inflation adjusted dollars in the future. If you believe that taxes are going to go up in the future, it might make sense for you to use a Backdoor Roth IRA.

This will allow you to pay taxes at a lower effective rate, and then enjoy tax free withdrawals in retirement when taxes are higher. Keep in mind this is a hypothetical scenario and should not be taken as financial advice. It is always a good idea with work with a competent financial advisor before deciding whether to do a Backdoor Roth IRA or not.

1) Potentially large tax bill - When done properly, a Backdoor Roth IRA should incur minimal to zero taxes. However, there are situations in which a Backdoor Roth IRA can trigger a large tax bill. Let's say that you had been contributing to a Traditional IRA for 5 years because you did not know that the Backdoor Roth IRA existed.

Let's assume that you contributed $7,000 to the Traditional IRA for the past 5 years and taken a deduction on these contributions. Let's also assume that your investments within the account went up by $7,000 during the 5 years that you contributed.

This would leave you with a total of $42,000. If you did a Backdoor Roth IRA conversion with the total $42,000 all that money would be subject to taxes. This can leave with a large tax bill that you would have to pay.

2) The 5 year rule - With a standard Roth IRA, you are allowed to withdraw your base contributions (not earnings) at any time since these contributions have already been taxed. For 2024, the max contribution is $7,000 or $8,000 per year if you are 50 or older.

You would be allowed to pull that amount of money out of a Roth IRA tax and penalty free. However, the rules are different for a Backdoor Roth IRA. The IRS views Backdoor Roth IRAs as conversions and not contributions.

This means that every time you make a Backdoor Roth IRA conversion, you must wait at least 5 years before you are allowed to withdraw your base contributions from the Backdoor Roth IRA tax and penalty free.

3) If taxes are lower in the future - If taxes end up being lower in the future a Backdoor Roth IRA might not make the most sense. Instead it would make more sense to leave the money in the Traditional IRA which gives you a tax break today and is taxed when you pull the money out in retirement.

In other words, it would make more sense to pay taxes later when they are lower. However, trying to predict future tax rates is challenging as no one knows exactly what the government will do 30 or 40 years in the future. As previously stated, it is a good idea to work with a financial expert before deciding.

The bottom line is that a Backdoor Roth IRA is a strategy used by high income earners to get around the income limitations of a standard Roth IRA. You can set up a Backdoor Roth IRA by making non-deductible contributions to a Traditional IRA and then converting those contributions to a Roth IRA.

A Backdoor Roth IRA can be a good strategy for some investors depending upon their individual circumstances. The tax implications and paper work of a Backdoor Roth IRA can be complex, so it is a good idea to work with a competent financial advisor when using a Backdoor Roth IRA strategy.