Backdoor Roth IRA: A Comprehensive Guide for Retirement Savings

The federal government wants people to save for retirement. That’s why U.S. tax laws provide people with generous tax benefits when they invest their dollars in an individual retirement savings account, better known as an IRA. You can take advantage of these tax savings while growing your retirement nest egg as long as you follow the IRS’ rules for withdrawing and depositing money in IRAs.

Those rules are especially important if you are considering a backdoor Roth IRA, a way to convert a traditional IRA to a Roth. A backdoor Roth IRA is an important tool for wealthier taxpayers: This investment strategy allows high-income taxpayers to contribute to a Roth IRA even if their yearly incomes would normally not allow them to do so.

Initiating a backdoor Roth IRA, though, can be a complicated task. It’s best to plan the strategy with an experienced financial advisor instead of attempting this move on your own.

Backdoor Roth IRA, Defined

A backdoor Roth IRA isn’t a type of IRA. It’s actually a way for taxpayers with higher incomes to contribute to a Roth. Think of it as a way to avoid the income limits for Roth IRA contributions. You invest money in a traditional IRA and convert that IRA to a Roth IRA. There is a downside here: You’ll have to pay income taxes on the money you convert to a Roth IRA. 

How Backdoor Roth IRAs Work

If you want to contribute to a Roth IRA but you make too much money each year, it might be time to try a backdoor Roth IRA.

Traditional IRA Vs. Roth IRA

There are two types of IRAs: traditional and Roth. The main difference between these two accounts is when your contributions are taxed. With a traditional IRA, your contributions are tax-deductible in the year in which you make them. With a Roth IRA, your contributions are not tax-deductible when you first make them. But when you withdraw money from your Roth IRA in retirement, you won't be taxed. When you withdraw money from a traditional IRA in retirement, you will pay taxes. This means that with a Roth IRA, your money will grow tax-free. With a traditional IRA, your money will grow tax-deferred, meaning you’ll eventually have to pay taxes on your earnings when you begin making withdrawals from your account in retirement.

Early withdrawals are also not as painful with a Roth IRA. You should avoid withdrawing funds from any IRA before you hit retirement age, of course. The purpose of an IRA is to build your retirement savings. You won't do that if you are withdrawing from your retirement accounts before you hit retirement age.

Withdrawing from your traditional IRA before you reach the age of 59½ will incur significant penalties. The IRA will impose a 10% early withdrawal penalty on the money you take out. You'll also have to pay taxes on the money you withdraw from your traditional IRA. There is no 10% penalty, though, for withdrawing money from a Roth IRA before you hit 59½. You also won't have to pay income taxes on these early withdrawals. Be aware, though, that you can only withdraw contributions – the money you put into an account, not the money you've earned on the account – without paying taxes. If you withdraw earnings before hitting 59½ you will have to pay the 10% penalty.

A traditional IRA also requires that you start taking required minimum distributions at the age of 72. This isn't the case with a Roth IRA. Unless you inherited your Roth, you can keep your money in this retirement vehicle for as long as you want without making any withdrawals.

The challenge with a Roth IRA is that there are strict limits on how much and at what income level taxpayers can contribute to a Roth. There are no income limits, though, on who can contribute to a traditional IRA. 

Why The Backdoor Approach?

Why would you consider a backdoor Roth IRA?

The first reason is to avoid the income limits the IRS imposes on Roth IRA contributions. For the 2020 tax year, couples who are married and filing jointly can only contribute to a Roth IRA if their modified adjusted gross income is below $206,000. Single taxpayers can only contribute to a Roth IRA if their modified adjusted gross income is below $139,000.

If you want to contribute to a Roth IRA and your yearly income is too high, a backdoor Roth is your only option. That’s because there are no limits on a traditional IRA. You can contribute to this kind of IRA no matter how much money you make. You can then convert your traditional IRA to a Roth IRA.

A backdoor Roth IRA can also help you avoid the contribution limits that come with these IRAs. For the 2020 tax year, you can only contribute a maximum of $6,000 to IRA accounts, whether you have a Roth, traditional or combination of accounts. This maximum increases to $7,000 if you 50 or older.

A backdoor Roth allows you to get around these limits, sort of. Say you have a traditional IRA with $50,000 in it. You can convert that entire amount to a Roth IRA, a dollar amount that is far higher than the $6,000 or $7,000 you'd normally be allowed to invest in a Roth IRA during the tax year. You can take the same approach if you need to rollover the money in a 401(k) plan after leaving a job: No matter how much money you have in your 401(k), you can invest it all in a Roth.

Is This A Tax Dodge?

A backdoor Roth IRA isn’t for everyone. But don’t let fear keep you from this strategy. There’s nothing illegal about a backdoor Roth IRA. The move is entirely within the IRS’ rules.

What Are The Benefits Of A Backdoor Roth IRA?

Still deciding whether a backdoor IRA is right for you? Here’s a look at the main benefits of such a move.

• In a traditional IRA, your money grows only a tax-deferred basis. You won’t pay taxes on your earnings before you hit retirement. But once you start withdrawing money from a traditional IRA, you will have to pay taxes on your investment earnings. With a Roth IRA, your income grows on a tax-free basis. When you make withdrawals from this account after the age of 59½ you won’t have to pay any taxes on your earnings
• It’s easier to withdraw money from a Roth IRA without suffering any penalties. You won’t have to pay income taxes or the IRS’ 10% penalty when you withdraw contributions to your Roth IRA, no matter how old you are. With a traditional IRA, you’ll pay a 10% penalty and income taxes on any money you withdraw before you turn 59½.
• You can keep your money in your Roth IRA for as long as you want. With a traditional IRA, you need to start making withdrawals once you turn 72. For every dollar you don’t withdraw, the IRS will charge a 50% penalty. This means that if you were supposed to withdraw $3,000, the IRS will charge you a penalty of $1,500.

How Do I Create A Backdoor Roth IRA?

Ready to initiate a backdoor Roth IRA? Here are the steps:

Contribute to a traditional IRA. Remember, if you are under 50 years of age, you can contribute a maximum of $6,000 a year to a traditional IRA. If you are 50 or older, you can contribute a maximum of $7,000 a year to a traditional IRA.

Convert your traditional IRA to a Roth IRA. To do this, contact the company managing your IRA. Your IRA administrator will provide you with the instructions and paperwork necessary to convert to a Roth IRA. If you don't already have a Roth IRA, you'll need to open a new account when you make your conversion.

Get ready to pay some taxes. Remember, the contributions you make to a traditional IRA are tax-deductible in the year you make them. If you deducted these contributions and then decide to convert your traditional IRA to a Roth, you'll have to pay income tax on the money you converted. How much you'll have to pay depends on something called the pro-rata rule, a topic covered later in this story.

Investment gains can hurt, too. If you didn't convert your traditional IRA to a Roth IRA immediately, the money you contributed might have gained value. You'll also owe taxes on these gains at income tax time after making a conversion to a back door Roth IRA.

Backdoor Roth IRA FAQs

What Are The Potential Drawbacks of a backdoor Roth IRA?

A Roth IRA isn't a good idea if you need the money in it quickly. There's a 5-year rule for Roth IRAs. If you don't wait at least 5 years before withdrawing money from a Roth, you'll get hit with a 10% penalty from the IRA on the money you take out. The tax hit is also a significant problem: Remember, you’ll have to pay at income tax time on the money you’ve converted from a traditional IRA to a Roth.

Should I Consult A Financial Planner?

You should always work with a financial planner when considering a backdoor Roth IRA. You want to make sure that your conversion goes smoothly and that you don’t break any IRS rules. A financial planner can also tell you what tax hit you might take at income tax time and what long-term gains making this move will entail. Of course, you want the long-term gains to be large enough to outweigh the immediate taxes you’ll have to pay.

Is A Backdoor Roth IRA Legal?

There is nothing illegal about a backdoor Roth IRA. Converting a traditional IRA to a Roth is a perfectly legal way to get around the contributions and income limits that could otherwise prevent you from investing in a Roth IRA.

Why Does The IRS Encourage This?

The IRS wants U.S. adults to save for their retirement. When people build retirement nest eggs, it places less pressure on the social safety net. Roth IRAs have also become popular retirement tools largely because the contributions to them grow tax-free. There is pressure, then, on the IRS to make these retirement savings tools available to more people. A backdoor Roth IRA is one way to do this.

Are 401(k) Rollovers Eligible for Backdoor Roth IRA Conversions?

If you leave your job, you will have the opportunity to rollover the funds in your 401(k) to a Roth IRA. You can also choose to rollover your funds to a traditional IRA. Just remember, rolling over your 401(k) into a Roth IRA will result in a tax hit. You'll have to pay income tax on your contributions to a Roth IRA, your employer-match contributions and your earnings. You won't pay taxes, though, if you rollover your 401(k) to a traditional IRA.

What Is The Pro-Rata Rule And How Will It Affect My Taxes?

The pro-rata rule determines how much of the money in a conversion to a Roth IRA is taxable. When you convert a traditional IRA to a Roth IRA, the IRS will look at all your traditional IRA accounts to determine what percentage of the dollars in these accounts is made up of pre-tax money and what percentage is after-tax money.

Say that in all your traditional IRAs combined, 60% of your funds is made up of pretax money and 30% after-tax dollars. In this example, 60% of the money you convert to a Roth IRA will be taxable. This ratio will remain no matter how much money you convert or from which traditional IRA account you take the money.

Timing is important, too. The IRS applies the pro-rata rule to your total IRA balance at the end of the year, not at the time of the conversion to a Roth IRA.

What Is A Mega Backdoor Roth IRA?

Have even more money you want to contribute to a Roth IRA? You might consider a mega backdoor Roth IRA.

This is a complicated financial maneuver that lets you contribute up to $37,500 in a Roth IRA or Roth 401(k) plan in 2020 in addition to the regular contribution limits for these retirement savings vehicles.

To make this financial move, you'll need to be enrolled in a 401(k) plan that allows after-tax contributions.

You'll also need to first max out the money you save in your 401(k) plan and Roth IRAs. In 2020, this means you'll need to save more than $25,500 if you're under 50: a maximum of $19,500 in your 401(k) and $6,000 to a Roth IRA. If you are 50 or older, you'd need to save the maximum of $26,000 to your 401(k) and a maximum of $7,000 to a Roth IRA.

Mega backdoor Roth IRAs are complex financial transactions. Don’t attempt one of these without working with a financial advisor.

Summary: Proceed Carefully With A Backdoor Roth IRA To Save On Taxes

A backdoor Roth IRA is a chance for more people to benefit from the long-term tax advantages of this type of retirement savings vehicle. The big advantage of a Roth IRA is that you won’t pay money on any withdrawals you make after the age of 59½, including your earnings. With a backdoor Roth IRA you won’t have to worry about income or contribution limits.

A backdoor Roth, though, is just one financial maneuver you can take to boost your financial health. It’s always smart to learn more about your personal finances.