If you are familiar with retirement plans, you probably already know how a traditional IRA works. Many people choose to place money into a Roth IRA to enjoy tax-free money at retirement.
However, the IRS places income limits on the ability to contribute to a Roth IRA. So, what happens if you exceed those income limits? There might still be a way that you can contribute to a Roth account even if your income is too high.
This is where the Backdoor Roth IRA strategy comes into play. This strategy can allow you to get money into a Roth account even if your income exceeds the IRS limits – and it’s legal! Keep reading as we explain how.
What Is A Backdoor Roth IRA?
A backdoor Roth IRA is not necessarily a retirement account. It is actually a strategy used by high-income households to skirt the IRS income limits for Roth account contributions.
Under normal circumstances, households with an annual gross income of more than $240,000 jointly cannot contribute to a Roth IRA account. However, since Roth IRA contributions can be withdrawn tax-free at retirement, many people prefer to utilize Roth accounts.
The backdoor Roth allows high-income households an avenue to fund a Roth IRA account.
- Essentially, they contribute money to a traditional IRA first since there are no income limits on traditional IRA contributions.
- As soon as the IRA is funded, they rollover the funds into a Roth account.
- In many cases, the contributions made to the Traditional IRA are on an after-tax basis, which means there are no tax implications when the rollover is performed.
So, once the money is rolled into a Roth IRA, the backdoor strategy is complete.
You must pay attention to a few more details, but we will explain those in more detail later in this article.
KEY TAKEAWAYS
- A Backdoor Roth IRA is a strategy high-earners use to fund their Roth IRA even when their income exceeds the eligibility limits.
- You can always contribute to a Traditional IRA since there are no income limitations. Once the funds are in the Traditional IRA, you can convert them into your Roth IRA account.
- You can only perform one Roth conversion per year and may be subject to taxes on the conversion.
Traditional vs Roth Account Basics
Roth and Traditional are the two main types of IRAs, and you should be aware of some key differences between them.
The first difference is eligibility. There are income limits that restrict eligibility to make Roth IRA contributions.
- These accounts are open to single tax filers with modified adjusted gross income (MAGI) of less than $161,000 and married couples with a MAGI of less than $240,000. However, contribution limits begin phasing out at $146,000 and $230,000, respectively.
- Traditional IRAs are open to anyone, although tax deductibility depends on income and participation in an employer-sponsored plan. Contributions are no longer tax deductible for single tax filers with modified adjusted gross income (MAGI) of less than $161,000 and married couples with a MAGI of less than $240,000. However, full deductibility begins phasing out at $146,000 and $230,000, respectively.
Note: You can always contribute the maximum allowed to your Traditional IRA. However, you may not always get the tax deduction.
The next significant difference between Roth and traditional IRAs is the IRS treatment of contributions and withdrawals.
- With a traditional IRA, the IRS allows you to take a tax deduction on your IRA contributions now. Still, your withdrawals of contributions and gains are treated as taxable income during retirement.
- A Roth account, on the other hand, requires after-tax contributions, so you do not get any tax breaks today. However, your contribution and gains grow tax-free, and you are not required to pay any taxes on your withdrawals.
Traditional IRA contributions are subject to required minimum distributions upon age 73; however, Roth IRA accounts have no minimum distribution requirements for the account owner. Beneficiaries will be subject to RMDs, but this rule can still lead to considerable tax savings in the long run.
Lastly, there is a difference in when you can access your retirement savings.
- You can only withdraw your money at 59 1/2 with a traditional account. Otherwise, you pay taxes and penalties.
- With a Roth account, you can withdraw your contributions anytime without paying taxes or penalties. Your investment gains must remain in the account until age 59 1/2 and for at least five years before being withdrawn tax and penalty-free.
| Traditional IRA | Roth IRA | |
|---|---|---|
|
Phase Out Rules |
Contributions are no longer tax deductible for single tax filers with modified adjusted gross income (MAGI) of less than $161,000 and married couples with a MAGI of less than $240,000.
Plusr, full deductibility begins phasing out at $146,000 and $230,000, respectively. |
You can only make contributions to these accounts as single tax filer if your modified adjusted gross income (MAGI) is less than $161,000 and married couples with a MAGI of less than $240,000.
Plus, contribution limits begin phasing out at $146,000 and $230,000, respectively. |
|
Contributions Limits |
In 2024, you can contribute up to $7,000
If you are 50 or older, you can contribute an additional $1,000 |
In 2024, you can contribute up to $7,000
If you are 50 or older, you can contribute an additional $1,000 |
|
Effects of Early Withdrawal |
Distribution taxed as income plus an additional 10% penalty for early withdrawal before age 59 1/2 |
No income taxes on distributions
Earnings withdrawn prior to age 59 1/2 are subject to a 10% penalty Original contributions can always be withdrawn tax-free |
|
Pros |
Contributions are tax deductible in current year |
Contributions can be withdrawn at any time without taxes or penalties
Distributions of both contributions and gains are tax-free |
|
Cons |
Withdrawals are taxed at current income tax rates
Early withdrawals may be subject to penalties |
Income limits restrict eligibility to contribute
No tax benefits for contributions in the current year |
Must read articles related to Retirement
- Which are the best states to retire?
- Leveraging a Mega Backdoor Roth 401(k) strategy to reduce taxes in retirement.
- A guide to understanding Profit Sharing plans.
- How does a Solo 401(k) benefit self-employed business owners?
- Should you participate in a cash balance plan?
4 Steps To Create A Backdoor Roth IRA
So, perhaps your income is too high to contribute to a Roth IRA, but you want to enjoy the tax benefits of a Roth. What can you do? Here are the steps you need to take to perform a Backdoor Roth IRA conversion.
1) Contribute To Traditional IRA
The process starts by contributing to a traditional IRA. Go ahead and max out the amount that you can place into your tax-deferred traditional account. Since there are no income limits on traditional IRA’s, you can fund this account regardless of your income level.
You can still make this contribution even if you are married, filing jointly, and making over $240,000. However, you can only perform one Roth conversion per year.
2) Perform Roth Conversion
Now it’s time to convert the traditional IRA account that you just created into a Roth account. There is nothing that prohibits high earners from performing this type of conversion.
To minimize the tax money that will be due, you will want to perform this conversion right away. The longer the money stays in the traditional account and grows, the more taxes you will have to pay.
3) Pay Necessary Taxes
When you perform the conversion, you will owe taxes on the money that gets converted. In addition, you will owe taxes on any growth in the account from the time you funded the traditional IRA until the time you performed the conversion.
This might increase your taxable income for the year and push you into a higher tax bracket. The pro rata rule applies in this case, so you might not have to pay the higher tax rate on all of the money. Make sure you file IRS Form 8606 when it comes tax time.
4) Watch Out For Capital Gains
Performing the Roth conversion can have some significant tax implications. Not only can you lose your tax deduction in the current year, but you might also owe some capital gains taxes when it comes time to file your tax return.
This is because you will owe tax on any growth in the account before the conversion is performed. Most brokerages that offer these accounts can help you with the specifics to determine whether the conversion makes sense for you.
It’s helpful to consult a tax professional and financial advisor before making these decisions.
Backdoor Roth IRA Tax Rules
There are a few special tax considerations regarding this backdoor IRA strategy. A converted Roth IRA is treated a little differently than Roth IRA contributions.
- We mentioned the taxes that will be due when you perform the conversion.
If you maxed out the IRA contribution limit of $7,000, you will owe taxes on all $7,000 plus any growth the account experienced before performing the conversion.
- In addition, you will have to wait to access your funds in the converted account.
You must wait five years before you can access your funds penalty-free. With regular Roth contributions, you can access your money penalty-free right away. However, that is not the case with a converted account. If you are over age 59 1/2, you may be eligible to access your money sooner.
TIP
A Backdoor Roth IRA strategy is an excellent way for high-earning people to circumvent the income limitations of regular Roth contributions. If you make after-tax contributions into your traditional IRA and convert them to a Roth immediately, you might avoid any potential tax liability.
Benefits Of A Backdoor Roth IRA
One of the most significant benefits people experience from a Roth account is enjoying those tax-free distributions.
Additionally, there are no early withdrawal penalties from a Roth account. When performing the backdoor strategy, you can still experience these same benefits.
However, make sure that you are aware of the conversion’s waiting period. You will have to wait five years after the conversion before you can access your funds penalty-free.
Another significant benefit of the Roth account is that there are no required minimum distributions (RMDs) beginning at age 73.
With a traditional IRA, you are required to start taking minimum distributions. The Roth account lets you get around this rule, and you can enjoy tax-deferred growth in the account until your death.
The backdoor strategy allows you to get around the Roth IRA income limits and enjoy those Roth benefits even if your income is high.
Married couples with a modified adjusted gross income (MAGI) of over $240,000 cannot contribute to Roth accounts. They would only have a traditional IRA available.
The backdoor strategy allows them to circumvent this rule and put their money into a Roth IRA.
Backdoor Roth IRA Disadvantages
The two significant disadvantages to this strategy are the tax implications and the waiting period to access your money.
When you perform the conversion, you might be left with a big tax bill, particularly if you lack the expertise to do things properly.
Additionally, you have a 5-year waiting period before accessing your money penalty-free. If you suspect that you might need that money before this period expires, you should likely consider another strategy for your retirement income.
You might consider making nondeductible contributions into another type of account, from which you can withdraw the money when needed without a penalty.
Your financial planner can help determine the right choice based on your personal finances.
The Bottom Line
Though your income might be too high to make Roth contributions to an IRA, there is still a way that you can get your money into a Roth account.
Contribute to a traditional IRA and then perform a Roth conversion. This is called a backdoor Roth IRA and can help you get around those pesky income limits.
This strategy has some tax implications, so understand precisely how this process works before attempting it.
If done correctly, it can help you enjoy the many benefits of a Roth account.
Frequently Asked Questions
Yes, this strategy is entirely legal. Just make sure you pay the due taxes and follow the IRS rules.
Your tax professional or brokerage should be able to help you with this strategy should you have any questions.
The Vanguard Roth IRA is a popular brokerage account option.
Yes, you can perform this strategy every year. However, you can only perform one IRA conversion per year.
You could contribute to a traditional IRA and convert it to a Roth account once every tax year.
The types of conversions available will depend on your employer’s plan rules.
If you have a Solo 401k for self-employed individuals, you have more flexibility in setting the rules.
Most of the time, there is no backdoor strategy available with employer-sponsored plans.
While you might be able to rollover into a Roth account, your plan documents will spell out the specific types of contributions and rollovers allowed.
It depends on your financial situation. If your income is above the Roth limits and you will not need to access the funds for the next five years, then the backdoor Roth might be a good idea for you.
Otherwise, this strategy might not make sense. You should also consider whether you have access to other retirement accounts, such as a pension or cash balance plan.
A Mega Backdoor Roth is a strategy similar to the backdoor Roth that allows you to put away up to an extra $46,000 into a Roth 401(k) or IRA.
This strategy requires following very specific rules, and you must have access to an employer-sponsored plan that allows for in-service rollovers.
You must follow the process very carefully or you might get stuck with a big unexpected tax bill.
You can find a Social Security Administration office near you by using our SSA office locator and searching for your closest location.
