What Is a Backdoor Roth IRA? (and How to Set It Up)

There are many different types of accounts that individuals can open to start saving for their retirement. However, high-income earners cannot contribute to a Roth IRA directly. Fortunately, there is a “backdoor” way for them to enjoy the benefits of a Roth account.

In this article, we will go over what a backdoor Roth IRA is, its benefits, and how to set it up. Keep reading until the end, as we will also answer some of the most frequently asked questions. Let’s get started!

What Is a Backdoor Roth IRA?

A Roth IRA is an individual retirement account that an investor can contribute to with after-tax dollars. However, they can only withdraw the money (principal investment plus the earnings) tax-free after they reach the age of 59½. Early withdrawals can lead to a 10% penalty.

Contrary to what many people believe, a backdoor Roth IRA is a strategy rather than an individual retirement account. Those who are in the high-tax bracket may be unable to contribute to a Roth IRA because of the income limits.

According to the Internal Revenue Service (IRS), the Roth IRA income limits for 2023 are as follows:

  • Less than $153,000 for single tax filers; and
  • Under $228,000 for married people who file their taxes jointly.

Any individual who earns more than the income limits prescribed by the IRS may want to consider a backdoor Roth IRA, a strategy that allows them to convert their traditional IRA to a Roth retirement account.

This investment strategy bypasses the income limits for those earning above $153,000 if they’re single and more than $228,000 if they’re married. It also allows the investor to reap the benefits of a Roth account.

When an individual transfers funds from a traditional IRA to a Roth IRA, they must pay taxes on the entire amount (principal, earnings, and appreciation). However, as with any Roth IRA, there are no taxes upon withdrawal if the investor follows the rules of the retirement account.

What Are the Benefits of Backdoor Roth IRAs?

After reading about the backdoor Roth IRA strategy, many people might be wondering why a taxpayer would go to such lengths simply to get around the income limits of the account.

Well, there are a few reasons for it, some of which include the following:

There Are No Required Minimum Distributions

Required minimum distributions (RMDs) refer to the amount of money an account holder must withdraw each year after their retirement.

Unlike a traditional IRA, which requires investors to take RMDs, a Roth IRA doesn’t have such a requirement. This means that the account holders can grow their savings tax-free for as long as they’re alive.

A Roth IRA doesn’t have any requirements on withdrawals and the frequency of withdrawals. This can be a great benefit for some individuals who may be looking to grow their savings or leave it all for their heirs.

There Is No Tax on Roth IRA Distributions

Another major benefit of a Roth account is that the individual does not have to pay taxes on backdoor Roth contributions. This translates to significant tax savings over the long run.

Since individuals pay taxes on their Roth IRA conversions, the withdrawals are tax-free if they follow the account rules properly.

The future is uncertain, and there could be a possibility of increased taxes. Anyone who wants to avoid a possible rise in future tax rates can convert to a Roth IRA and pay their taxes now.

Also, if you’re not looking for information on the gold IRA rules and regulations then you’re not doing all your homework!

Backdoor Roth Conversions: How Can Individuals Set up Backdoor Roth IRAs?

There are two ways in which an individual can set up a backdoor Roth IRA, and these are as follows:

A Roth IRA Rollover

Under this method, an investor must contribute money to a traditional IRA with no balance. Following this strategy with a balance in their account may trigger a tax event upon conversion.

After contributing to the traditional IRA, the individual must wait for the holding period to pass before they can request to convert the retirement account to a Roth IRA. It is important to note that any earnings made in the traditional IRA before the conversion will be taxable.

The investor must also fill out the IRS Form 8606 and complete their tax return to ensure that the Roth IRA consider their contribution as nondeductible. When establishing a backdoor Roth IRA, the individual does not gain any tax benefit for that year.

A 401(k) Rollover

Some employer-sponsored retirement accounts may allow the employee to do a backdoor Roth IRA conversion.

In some cases, a 401(k) plan may allow automatic Roth conversion, which means that the individual can make after-tax contributions and then have them converted automatically to Roth.

It’s best for employees to check with their employers on whether this option is available to them.

A Backdoor Roth Conversion Could Have Tax Implications

Backdoor Roth Conversion Could Have Tax Implications

A backdoor Roth IRA conversion can have serious tax implications, which can complicate the entire process, especially if the individual has more than one traditional IRA.

It’s crucial to not only understand the tax consequences but also where to get the cash to pay for the taxes.

In a Roth conversion, all deductible contributions or the earnings on all types of contributions are typically taxed at the marginal tax rate. If an individual has multiple IRAs, they must determine the contributions they’ve made to each of those retirement accounts for taxation purposes.

When executing a backdoor Roth IRA conversion, the deductible contributions are often taxed, while the nondeductible contributions are tax-free. What makes the entire process complex is that the individual does not have control over the type of contribution they choose to transfer.

According to the IRS, the average deductible contributions and earnings to nondeductible contributions ratio for all of the traditional IRAs is crucial in determining tax liability. The IRS uses the IRA aggregation rule, meaning that the revenue service for the United States federal government views multiple IRAs as a single entity.

We understand how technical a backdoor Roth IRA conversion can get, which is why we’ve provided an easy-to-understand example below:

Suppose an investor has multiple traditional IRAs worth $100,000, which contain 20% nondeductible contributions and 80% in deductible contributions. If they decide to convert $10,000 to a Roth IRA, they must pay taxes on the $8,000 ($10,000 x 80%) they convert.

When Should an Individual Avoid a Backdoor Roth IRA?

Even if you are a high-income earner, opening up a backdoor Roth IRA may not always be the best option for you. This is because they may have a different financial situation than others.

Here are a few situations where one should avoid a backdoor Roth IRA:

Immediate or Unexpected Future Expenses

A high-income earner may be comfortable opening up a backdoor Roth IRA, but what if they need to withdraw in the near future to pay for unexpected expenses? Early withdrawals can lead to a 10% penalty, which may reduce the earnings made through the retirement account.

If an individual doesn’t have enough cash stashed away for a rainy day, they may want to hold off on opening a backdoor Roth IRA. Life can be unpredictable and unexpected expenses can come as a shock, even for high-income earners.

Probability of Messing Up the Process

A backdoor Roth IRA is an excellent strategy for high-income earners, but if they manage the entire process incorrectly, it can lead to costly tax errors.

Suppose an individual feels that they’re not confident in executing the backdoor Roth IRA strategy or handling the pro-rata rule. In that case, they should either avoid it or consult with an experienced financial planner.

A 401(k) Rollover

In cases where an employee rolls over their 401(k) balance from a former employer to an IRA, they may have to pay additional taxes if they decide to execute the backdoor Roth IRA strategy that same year.

Final Thoughts – Is a Backdoor Roth Strategy a Good Option to Pursue?

A backdoor Roth IRA contribution can be a fantastic option for high-income earners looking to reap the benefits of a Roth account. However, it is a complicated process with serious tax implications, which is why individuals must be careful when converting funds from traditional IRAs.

We recommend that everyone who is looking to convert a traditional IRA to a Roth account must consult with an experienced financial planner first. They can help assess their situation, evaluate the tax implications, and guide them accordingly.

Frequently Asked Questions

How Much Should Individuals Contribute to a Roth IRA?

The Roth IRA contribution limits on funding the account, as per the 2023 IRS notification, is $6,500 or $7,500 if the individual is 50 years or older.

However, the amount an individual should contribute to a Roth IRA varies from one person to another. If the account holder has an excellent financial standing and can afford the maximum limit, they should consider maxing out their Roth IRA.

How Does a Backdoor Roth Work?

To execute the backdoor Roth conversion, an individual must make nondeductible contributions to their traditional IRA. Unlike a Roth IRA, this type of account does not have income limits.

After making traditional IRA contributions, the account holder can request a conversion to a Roth account. The conversion is non-taxable if the account does not accrue any earnings. However, if there are earnings before the conversion, they will be taxable.

It’s best to execute the backdoor Roth IRA conversion as soon as possible to avoid collecting earnings, which can make the entire process more complicated than it already is. We recommend everyone, who wants to open a backdoor Roth IRA account, should consult with an experienced financial advisor.

Are There Any Penalties on Backdoor Roth IRA Contributions?

When an individual converts their contributions to a backdoor Roth IRA, it’s commonly referred to as “converted funds.” Contributions refer to the money an investor invests into the retirement account, which differs from earnings.

If the account holder is under the age of 59½, they must wait for five years before they can access their contributions without facing any penalties. This is not the case with a Roth IRA, where the account holder can withdraw their contributions at any time without incurring penalties.

What Is the Congress’s View on Backdoor Roth IRAs?

As of August 2023, the law allows individuals to take advantage of the backdoor Roth IRA strategy. However, there are legislative efforts by Congress that focus on the benefits of contributing to a Roth rather than conversions.

It’s best for an investor to speak to an experienced financial advisor to help them adhere to the conversion rules or learn more about the impact it could have on their financial situation.