Simple Guide to Backdoor Roth IRAs

Roth IRAs are a popular retirement savings option for many investors because you invest after-tax funds, which means you don’t typically pay taxes when you withdraw the funds in retirement. 

However, Roth IRAs have income limitations on who is eligible to contribute to them. For investors who earn too much to qualify, one option to consider is funding a Roth IRA by using a backdoor Roth IRA.

Learn how a backdoor Roth IRA works and some of the benefits of this approach in saving for retirement.

What is a Roth IRA?

A Roth IRA has several characteristics:

• Contributions are made with funds that have already been taxed.
• If certain conditions are met, withdrawals are tax-free.
• Money held in a Roth IRA is exempt from required minimum distribution requirements.

The 2024 IRA annual contribution limit is $7,000 with an additional $1,000 catch-up contribution available to those who are 50 and older. All or any portion of this limit could be contributed to a Roth IRA as long as your income level is below the limit for contributing to a Roth IRA.

The income limits that qualify you for contributing to a Roth IRA are based on your modified adjusted gross income (MAGI). MAGI is calculated by taking your adjusted gross income (AGI) from your tax return and adding back certain tax deductions. For tax year 2024, the MAGI limits to be able to contribute to a Roth IRA are:

Filing status	2024 MAGI	Contribution limits
Married couples filing joint or qualified widow	Less than $230,000	No contribution restrictions
	$230,000 to $240,000 (less than $240,000)	Contributions are reduced
	Equal to $240,000 and above	No Roth IRA contributions allowed
Single, head of household, or married filing separately and you didn’t live with spouse at any point during the year	Less than $146,000	No contribution restrictions
	$146,000 to $161,000 (less than $161,000)	Contributions are reduced
	Equal to $161,000 and above	No Roth IRA contributions allowed
Married filing separately and you lived with your spouse at any point during the year	Less than $10,000	Contributions are reduced
	$10,000 or more	No Roth IRA contributions allowed

According to IRS rules, Roth contributions can typically be withdrawn tax and penalty-free.

Roth IRA withdrawals that include the interest you’ve earned could be made tax and penalty-free if the account holder has satisfied the five-year rule and is at least 59 1/2 years of age.

The five-year rule says that you must wait five years from your initial Roth IRA contribution to withdraw the earnings in your account tax-free. Even if you have reached the age of 59 1/2, your withdrawals will not be tax-free if you have not satisfied the five-year rule.

Additionally, each Roth conversion, including conversions tied to a backdoor Roth IRA, has its own five-year timeline.

The five-year rule must also be satisfied by the original account holder for most non-spousal beneficiaries to be able to take distributions from an inherited Roth IRA on a tax-free basis.

What is a backdoor Roth IRA?

“Backdoor IRA” is an informal name for the strategy sometimes used by higher-income taxpayers. It involves converting traditional IRA funds into a Roth IRA because the taxpayer exceeds the income limits to contribute directly to a Roth IRA. A backdoor Roth IRA involves an after-tax traditional IRA contribution, then converting the contribution (and perhaps other traditional IRA money) to a Roth IRA.

The benefit of a Roth conversion, whether a backdoor Roth conversion or not, is that it’s a way for an investor to move more of their retirement savings to a Roth account. Besides converting a traditional IRA to a Roth IRA, many plans allow the conversion of money in a traditional 401(k) to a Roth option.

The reasons to convert to a Roth IRA include the ability to withdraw funds tax-free in retirement and the exemption from the required minimum distributions you find in traditional IRAs. Note that money in a Roth 401(k) would be subject to required minimum distributions, but this money could be rolled over to a Roth IRA once you leave the employer.

Another reason to convert to a Roth IRA is the ability to leave a Roth IRA to non-spousal beneficiaries tax-free if certain conditions are met.

How to execute a backdoor Roth IRA

A backdoor Roth IRA starts with a non-deductible traditional IRA contribution. The contribution is then converted to a Roth IRA. The conversion could be directed to a new or existing Roth IRA.

It’s important to ensure you have a traditional IRA account to receive the after-tax deposit and a Roth IRA to receive the proceeds of the conversion.

Once you make the post-tax contribution, you could generally convert the money almost immediately to a Roth IRA.

What are the tax consequences of a backdoor Roth IRA?

In general, it’s important to understand that a conversion from a traditional IRA to a Roth IRA or from a traditional 401(k) to a Roth 401(k) is a taxable event. The money you convert to a Roth IRA will be taxed at your ordinary income tax rate (based on your tax bracket) with the exception of the money contributed to the traditional IRA on an after-tax basis.

Besides any federal tax liability, there may be state income taxes due. This varies by state, so be sure to verify how Roth conversions are taxed where you live. For example, my home state of Illinois does not levy a tax on Roth conversions.

The execution of a backdoor Roth IRA is relatively simple. However, there are a number of planning issues to consider due to the potential tax consequences of a backdoor Roth conversion.

In simple terms, you contribute to a traditional IRA on an after-tax basis, then convert these funds to a Roth IRA. If you don’t have other money in a traditional IRA account, the conversion could be tax-free. For example, let’s say you contributed $6,000 to a traditional IRA and don’t hold other funds in any other IRAs. If there were no earnings on this IRA contribution, then the conversion to a Roth IRA could be totally tax-free.

The pro-rata rule comes into play if you do have other money in traditional IRA accounts. The taxable amount of your conversion is based on the ratio of pre-tax contributions to your total IRA balance across all your traditional and Roth IRAs.

Here is an example:

• You made an after-tax contribution of $6,000 to a traditional IRA in the previous tax year.
• The total amount in all your traditional IRA accounts is $100,000.
• The total amount attributed to tax-deductible contributions and earnings is $80,000, or 80%, of the total amount in all your traditional IRA accounts.

In this example, if you converted the $6,000 to a Roth IRA, 80%, or $4,800, of the converted amount would be taxable.

The pro-rata rule applies to all Roth IRA conversions, not just to backdoor Roth IRAs.

One way around the pro-rata rule is to roll money in a traditional IRA over to your current employer’s 401(k) plan if your plan allows for this. 

What are the benefits of a backdoor Roth IRA?

A backdoor Roth IRA is a way of diverting additional retirement dollars to a Roth account. A Roth IRA offers several benefits:

• The money won’t be taxed later on in retirement. This could offer tax diversification among your retirement accounts.
• Money in a Roth IRA is not subject to required minimum distributions. This means the money doesn’t have to be withdrawn from the Roth IRA and can be left to grow tax-free in the account.
• Due to changes in the rules for inherited IRAs arising from the SECURE Act, it could offer tax advantages to pass on money in a Roth IRA versus a traditional IRA.

FAQs

Bottom line

The backdoor Roth IRA conversion is a tactic that gives investors whose income is too high to contribute directly to a Roth IRA the ability to contribute indirectly to a Roth IRA each year.

A backdoor Roth IRA strategy involves making a non-deductible contribution to a traditional IRA on an after-tax basis, then converting this contribution to a Roth IRA. 

If you’re contemplating a backdoor Roth IRA, keep an eye on any legislative developments. For example, Congress proposed a change in the Build Back Better bill that would have effectively ended the ability to use a backdoor Roth IRA by prohibiting the conversion of after-tax dollars to a Roth IRA. That change didn’t pass. For now, there’s no reason to worry about this, but this could be back on the legislative table at some point.