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Backdoor Roth IRA | What Is It & How It Works (Full Guide)

Backdoor Roth Ira Retirement Planning Concept

If you are familiar with retirement plans, then you probably already know how a traditional IRA works. Many people choose to place money into a Roth IRA so that they can enjoy the money tax-free 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 totally legal! Keep reading as we explain how.


What Is A Backdoor Roth IRA?

A backdoor Roth IRA is not necessarily a retirement account on its own. It is actually a strategy that is used by high-income households to skirt the IRS income limits for Roth account contributions. Under normal circumstances, households with annual gross income of more than $208,000 jointly cannot contribute to a Roth IRA account at all. However, since Roth IRA contributions can be withdrawn tax-free at retirement, many people prefer to utilize Roth accounts.

The backdoor Roth allows these households a way to get money into Roth retirement savings. Essentially, they contribute money to a traditional IRA first. There are no income limits on traditional IRA contributions. As soon as the IRA is funded, they then perform a rollover of that IRA into a Roth. There are likewise no income limits for Roth IRA conversions. So, once the money is rolled into a Roth IRA, the backdoor strategy is complete. There are a few more details that you must pay attention to, but we will explain those in more detail later in this article.

Traditional VS Roth Account Basics

Let’s take a look at the basic differences between traditional and Roth IRA’s. Traditional IRA’s act like most traditional retirement savings accounts. You make pre-tax contributions into a traditional IRA. This means that the money that goes into the account is tax deductible in the current year. This can help lower your tax bracket in the current year and save taxpayers some money. Additionally, the investments in your account can enjoy tax-free growth until retirement. Each year, you can contribute up to $6,000 into your IRA and up to $7,000 if you are age 50 and older. Upon reaching retirement age, you can withdraw the money. You will pay regular income taxes on the money depending on your current tax bracket when you make the withdrawals. Non-deductible traditional IRA’s offer no immediate tax benefits, and they are rarely used for retirement planning.

When it comes to a Roth, your contributions are made on an after-tax basis. This means that you do not get any tax breaks in the current tax year. However, at retirement age, you will not have a tax bill at all. You get to make tax-free withdrawals from your Roth account! Similar to a traditional account, you can only contribute up to $6,000 per year into your Roth IRA and up to $7,000 if you are age 50 and older. In addition, high-income earners are prohibited by IRS rules from contributing to Roth IRA’s at all. For married couples filing jointly, this limit is $208,000 in 2021. When deciding which type of individual retirement account is right for you, you should contact your financial advisor if you have any questions.

These basics apply to both IRA and 401k accounts. A Roth 401(k) functions similarly. It allows you to place after-tax dollars into the account and enjoy tax-free growth. Upon reaching retirement age, you will only owe taxes on the growth in the account.


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.


​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. Even if you are married filing jointly and making more than $208,000, you can still make this contribution. Just know that you can only perform one Roth conversion per year.


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.


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.


Watch Out For Capital Gains

Performing the Roth conversion can have some major 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. Always consult a tax professional before making these decisions.


Backdoor Roth IRA Tax Rules

There are a few special tax considerations that you should know when it comes to this backdoor IRA strategy. A converted Roth IRA is treated a little differently than Roth IRA contributions. First, we have already talked about the taxes that will be due when you perform the conversion. If you maxed out the IRA contribution limit of $6,000, then you will owe taxes on all $6,000 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 will need to wait 5 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, then you may have eligibility to access your money sooner.


Benefits Of A Backdoor Roth IRA

One of the biggest benefits that people experience from a Roth account is getting to enjoy 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 waiting period on the conversion. You will have to wait 5 years after the conversion before you get penalty-free access to your funds.

Another big benefit of the Roth account is the fact that there are no required minimum distributions (RMD’s) beginning at age 72. 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 all the way until the time of your death.

The backdoor strategy allows you to get around the Roth IRA income limits and still enjoy those Roth benefits even if your income is high. For married couples with a modified adjusted gross income (MAGI) of more than $208,000, they are not allowed to contribute to Roth accounts. They would only have a traditional IRA or SEP IRA available. The backdoor strategy allows them to get around this rule and get their money into a Roth IRA.


Backdoor Roth IRA Disadvantages

The two big 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 do not have the expertise needed to do things properly. Additionally, you have a 5 year waiting period before being able to access your money penalty-free. If you suspect that you might need that money before this period expires, then you should likely consider another strategy for your retirement income. You might consider making nondeductible contributions into another type of account so that 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. Simply contribute to a traditional IRA and then perform a Roth conversion. This is known as a backdoor Roth IRA and can help you get around those pesky income limits. There are some tax implications from this strategy, so make sure that you understand exactly how this process works before attempting it. If done properly, it can help you enjoy the many benefits of a Roth account.


Frequently Asked Questions


Is a Backdoor Roth IRA legal?

Yes, this strategy is completely legal. Just make sure that you pay the taxes that are due 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 option when it comes to choosing a brokerage account.


Can I do a backdoor Roth every year?

Yes, you can perform this strategy every year. However, you can only perform one IRA conversion per year. So, you could contribute to a traditional IRA and convert that IRA to a Roth account once every tax year.


Can I do a backdoor Roth with an employer-sponsored retirement plan?

The types of conversions available will depend on the rules of your employer’s plan. If you have a Solo 401k for self-employed individuals, then you can somewhat set your own rules. Most of the time, there is no backdoor strategy available with employer sponsored plans. While you might be able to perform a rollover into a Roth account, your plan documents will spell out the specific types of contributions and rollovers allowed.


Is a backdoor Roth a good idea?

It depends on your financial situation. If your income is above the Roth limits and you will have no need to access the funds for the next 5 years, then the backdoor Roth might be a good idea for you. Otherwise, it might not make sense to follow this strategy. You should also consider whether you have access to other retirement accounts like a pension or cash balance plan.


What is a Mega Backdoor Roth?

A Mega Backdoor Roth is a strategy similar to the backdoor Roth that allows you to put away up to an extra $45,000 into a Roth IRA or 401k. This strategy requires very specific rules to be followed, 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.