What a backdoor Roth IRA is and how to use it (2024)

As you’re building your nest egg, Roth options can be valuable.

One of the greatest benefits of a Roth IRA is that qualified investors can enjoy tax-free withdrawals of their money in retirement. A “backdoor” Roth IRA allows people with high incomes to sidestep the Roth IRA’s income limits.

What is a backdoor Roth IRA?

A backdoor Roth IRA essentially lets you convert yournondeductible traditional IRAcontribution to a Roth IRA, even if your income is too high to make a Roth IRA contribution. If performed correctly, the backdoor Roth conversion does not have tax consequences.

Read more: Roth IRA contribution limits

How does a backdoor Roth IRA work?

To make a backdoor Roth IRA conversion, first you will make a nondeductible contribution to a traditional IRA. Unlike a Roth IRA, the traditional IRA has no income ceiling for nondeductible contributions.

Then you will convert the nondeductible IRA contribution to your Roth IRA. If there are no earnings on the converted funds, the conversion is a nontaxable event (unlike if you were to convert pretax IRA funds into a Roth, in which case you pay taxes on the converted amount at your current ordinary income rate).

An important consideration is your eligibility to make regular Roth IRA contributions, based on yourmodified adjusted gross income(MAGI) andtax-filing status(single, married filing jointly, married filing separately). This will determine if you areeligible to contribute to a Roth IRA.1

If you file taxes as a single person, your MAGI must be under $153,000 for tax year 2023 and $161,000 for tax year 2024 to contribute to a Roth IRA. If you're married and file jointly, your MAGI must be under $228,000 for tax year 2023 and $240,000 for tax year 2024.

If your current MAGI exceeds the limit given your tax filing status, you may be able to leverage a backdoor Roth conversion for your retirement savings.

Roth IRA vs Traditional IRA

There are various types of IRAs; two common ones areRoth IRAsand traditional IRAs. They work similarly in terms of their self-directed nature and contribution limits but differ when it comes to their tax advantage.

With a Roth IRA, you contribute after-tax dollars, your money grows tax-free, and you can generally make tax- and penalty-free withdrawals after age 59½. On the other hand, traditional IRAs have an upfront tax advantage by lowering your Adjusted Gross Income (AGI). With a traditional IRA, you contribute pre-tax dollars and withdrawals are taxed as current income after age 59½.

Read more: Roth vs traditional IRAs: Which should I choose?

Four easy steps to execute a backdoor Roth IRA

1. Open and make a nondeductible contribution to a new traditional IRA or contribute to an existing traditional IRA

You can open an IRA at most financial institutions, both brick and mortar and online. In 2023, you can contribute up to $6,500 to a traditional IRA or $7,500 if you’re age 50 or over.2

2. Research how a Roth IRA conversion works

It might be wise to reach out to a financial professional for help. Consider consulting with a financial professionalprior to executing a backdoor Roth conversion. You may need to include additional tax forms with your annual federal and state tax filings.

3. Convert your contributions to a Roth IRA

The nondeductible contribution principal amount won’t be taxable as with a normal Roth IRA conversion, but the earnings will be taxable. It may make sense to make the conversion as quickly as possible to minimize taxable earnings.

4. Repeat these steps annually

You can continue to do so for as long as this strategy remains appropriate for your financial situation.

Key considerations for a backdoor Roth IRA

Here are some important things to consider before performing a backdoor Roth IRA:

Are backdoor Roth IRAs allowed in 2022?TheBuild Back Better Actwould have ended backdoor Roth IRAs starting in 2022. With this legislation currently on the backburner, however, the strategy remains alive and well, at least for now.3

What are the tax implications of a backdoor Roth IRA?There might be some instances where you will need to pay taxes with a backdoor Roth IRA, such as:

If you included pretax IRA assets in the conversion:If you deducted your traditional IRA contributions and then decided to convert your traditional IRA to a Roth IRA, you’ll need to pay taxes on the pretax assets. When it comes time to file your tax return, be prepared to pay income tax on the pretax dollars you converted to a Roth. If you have other pretax IRA assets remaining after your backdoor conversion.This is known as the pro rata rule.

The pro rata rule:One of the most important rules relevant to the backdoor Roth conversion is the pro rata rule.This is an IRS rule4that determines what amount is subject (or not) to taxes when you convert IRA dollars from a traditional IRA to a Roth IRA. To put it simply, if you attempt to convert after-tax traditional IRA contributions to a Roth IRA, but there are existing pretax IRA dollars, you will be subject to taxation on a prorated basis.

When determining your tax bill on a conversion from a traditional IRA to a Roth IRA, the IRS is going to look at all of your IRA accounts combined. For example, if all of your IRAs combined consist of 80% pretax money and 20% after-tax money, that 80/20 ratio determines what percentage of the after-tax money you convert to a Roth is going to be taxable.

For this specific example, no matter how much money you convert or which pretax IRA account you pull the money from, 80% of the amount you convert to the Roth will be taxable. The IRS applies the pro rata rule to your total IRA balance at year-end, not at the time of conversion.

The five-year rule:This rule dictates a five-year waiting period before earnings or converted IRA funds can be withdrawn from the account on a tax-free basis. To withdraw earnings from a Roth IRA without owing taxes or penalties, you must be at least 59½ years old and have held the account for at least five tax years.If funds are withdrawn earlier, you may have to pay taxes on any earnings and potentially will incur a 10% penalty unless you are age 59½ or older.

Transfers with backdoor Roth IRAs:Keep in mind that the conversion needs to fall within one of the following options:

  • A rollover, where you receive funds from your IRA and deposit the money into the Roth account within 60 days
  • A trustee-to-trustee transfer, in which the IRA provider sends your funds directly to the Roth IRA provider
  • A “same trustee transfer,” in which both the traditional and the Roth IRA are with the same financial institution

Is a backdoor Roth IRA worth it?

Depending on several factors, the backdoor Roth conversion may not fit everyone’s financial strategies and goals. For example:

1. You may not need a backdoor Roth conversion if you are able to meet your savings goals with the maximum retirement limit through yourworkplace retirement account, and are not expecting a need for additional savings.

2. If you already have pretax money in a traditional IRA, because of the pro rata rule, it may not end up being advantageous from a tax perspective to convert.

3. It’s worth noting thatinherited IRAsare not included in the pro rata calculation.

4. You should be willing to keep the funds in the newly created Roth IRA for at least five years before withdrawing the money.

5. You may want to keep the money in the traditional IRA if you are in a high tax bracket now and expect to be in a lower tax bracket upon retirement.

6. If you plan to relocate to alower income tax stateor astate where there are no income taxes.

On the other hand, a backdoor Roth conversion can be something to consider if:

1. You’ve already maxed out other retirement savings options.

2. You are a high-income earner.

3. You’re willing to leave the money in the Roth for at least five years (ideally longer).

4. You do not have other Roth assets.

Suggested next steps for you

If you meet the 4 criteria outlined above, a backdoor Roth IRA strategy could be the right decision for you. Backdoor Roth IRA contributions can equate to significant tax savings over time, as Roth IRA distributions, unlike traditional IRA distributions, are not taxable.

Before moving ahead with a backdoor Roth IRA, consider working with a financial advisor or tax professional to ensure you fully understand any potential tax implications.

Backdoor Roth IRA FAQ

What is the difference between a Roth IRA and a backdoor Roth IRA?

A Roth IRA is a type of individual retirement account which allows tax-free withdrawals in retirement. When you have a Roth IRA, you contribute after-tax dollars — up to a certain limit every year. For 2024, the limit5is $161,000for single filers and $240,000 for married couples filing jointly.

A “backdoor” Roth IRA allows high earners to sidestep the Roth IRA’s income limits by converting nondeductible traditional IRA contributions to a Roth IRA. That typically requires you to pay income taxes on funds being rolled into the Roth account that have not previously been taxed.

What is a mega backdoor Roth IRA?

A mega backdoor Roth allows high earners — who’s modified adjusted gross income (MAGI) is too high to open or contribute to a Roth IRA – to rollover money from a 401(k) account to a Roth IRA or Roth 401(k). A mega backdoor Roth lets you roll over up to $46,500 from a traditional 401(k) to a Roth IRA or a Roth 401(k) in 2024.

You can only perform a mega backdoor Roth under the following conditions.

  • You participate in a 401k plan at work that allows after-tax contributions. Regular 401k contributions are made on an elective deferral, or pre-tax, basis. Fewer than half of 401k plans allow after-tax contributions, so check with your benefit plan administrator before moving forward.
  • The 401k plan allows in-service distributions to a Roth IRA or transfer of funds out of the after-tax portion of the account into a Roth 401k. If it doesn’t, you’ll have to wait until after you leave the company to perform a mega backdoor Roth.
What a backdoor Roth IRA is and how to use it (2024)
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