Backdoor Roth IRA: What It Is And How To Use One

A Roth IRA is a tax-advantaged retirement plan in which you pay the taxes on the funds going into the account, but you don’t pay on qualified withdrawals. This is considered by some to be preferable to a 401(k) where you pay tax on withdrawal, on the theory that taxes rise over time. While income restrictions limit availability, a backdoor Roth IRA could help you sidestep them.

We’ll reiterate this a couple of times throughout this post, but this article is intended to provide general information. It shouldn’t be taken as tax advice. For personalized recommendations, please speak to a tax professional.

What Is A Backdoor Roth IRA?

A backdoor Roth IRA lets those who exceed Roth IRA income limits roll traditional IRA funds into a Roth IRA. You can transfer some of your IRA balance or fully convert it to a Roth IRA. Either way, you’ll pay taxes on the amount you convert.

Backdoor Roth IRA Vs. Traditional IRA

Since a backdoor Roth IRA is just a way of setting up the account to get around IRS income limits, we’re really just comparing the difference between a Roth IRA and a traditional IRA.

The first big difference is you pay taxes on the money going into the Roth IRA versus when it comes out on a traditional IRA. Also, traditional IRAs have a required minimum distribution (RMD) – you must make withdrawals – at age 73 (72 if that birthday was on or before December 31, 2022). Roth IRAs don’t require withdrawals before the account holder passes.

How Does A Backdoor Roth IRA Work?

The process for creating a backdoor Roth IRA involves converting a traditional IRA into a Roth IRA. When you do this, you open a traditional IRA first and then do the conversion. If you’ve made only pretax contributions to this account, your taxed at the normal rate for your income at the time of the conversion.

Where things get complicated is if you’ve made both pretax and after-tax contributions. The IRS doesn’t allow you to only convert after-tax amounts to a Roth IRA. Because of this, the retirement contributions that you’re converting (rolling over in government lingo) must be taxed on a pro rata basis and include both pretax and posttax contributions. Here’s how that works:

Let’s say you have $200,000 and you want to convert the entire amount. Of that amount, $50,000 is posttax contributions, and $150,000 is pretax, meaning there is a 75%/25% mix of pretax to posttax funds. When you take distributions later, 75% of the distribution would come from pretax funds that were then taxed, which could limit the tax advantage of a Roth.

If you’re not converting the entire amount, but you only want to take the $50,000 and convert it to a Roth IRA, you would pay taxes on 75% of that amount because 75% of your total IRA balance is taxable. So, the taxable amount would come out to $37,500.

For the purposes of this section, we been assuming you’re only dealing with one traditional IRA account. If you have multiple traditional IRA accounts, all of your accounts count for the purpose of determining the tax mix.

Finally, even if you’ve contributed all posttax funds to any IRA accounts, earnings in investments that accrued before the conversion from a traditional IRA to a Roth IRA are taxable, so you’ll have to pay the tax on any investment earnings. We’ve just gone over a lot of very complex tax policy. Again, speak to a tax pro about your situation before making any financial decisions.

Roth IRA Income Limits

Roth IRA income limits are based on modified adjusted gross income (MAGI). MAGI is adjusted gross income (AGI) with certain deductions added back in, including but not limited to qualified tuition expenses and IRA contributions.

Here’s a table breaking down income limits for 2023 and 2024 by filing status. We’ve also included the income impact on traditional Roth IRA contributions. We say traditional Roth IRA as a way of distinguishing from a backdoor Roth IRA. There aren’t income limits to contribute to a traditional IRA.

Backdoor Roth IRA Pros And Cons

The following are benefits and disadvantages of a backdoor Roth IRA.

How To Set Up A Backdoor Roth IRA In 3 Steps

In order to set up a backdoor Roth IRA, here’s how you would go about it. For the sake of simplicity, we’re assuming no existing IRA funds.

1. Open A Traditional IRA

First, you want to take this step of opening a traditional IRA. Once you’ve done this, the most important thing in terms of simplifying the conversion process is to contribute only posttax funds.

2. Roll Your Traditional IRA Funds Over To A Roth IRA

After you’ve had the traditional IRA for a while, it’s time to do the conversion to a Roth IRA. Work with your financial advisor to make sure everything goes smoothly.

3. Pay Any Taxes Owed On The Amount Rolled Over

Even in the best-case scenario in which you contribute only posttax funds, you would still owe taxes on any investment earnings included in your funds prior to the conversion. This simplified explanation doesn’t contemplate this, but you would also pay taxes if you had other pretax IRAs on a pro-rata basis relative to the total number of IRA funds.

Backdoor Roth IRA FAQs

We’ve touched on the key points, but let’s try to answer several other questions as well.

Is a backdoor Roth IRA legal?

Despite being a “backdoor,” the strategy is certainly legal. You just have to make sure to follow all IRS rules regarding the conversion and any distributions taken down the line.

When should I do a backdoor Roth IRA?

It’s best to do this when you want to have a Roth IRA, but you make too much money to do so. You would contribute to a traditional IRA, ideally with posttax income, and then convert that to a Roth IRA.

Are backdoor Roth conversions taxable?

The pro-rata rule determines how much of the money in a conversion to a Roth IRA is taxable. The IRS looks at your traditional IRA accounts to determine what percentage in these accounts are made up of pretax money and what percentage is after-tax money. Earnings from your traditional IRA are also taxable even if the original contribution came from posttax funds.

When shouldn’t I use a backdoor Roth IRA?

It may not make sense to consider a backdoor Roth IRA if you fall within the income limits of contributing to a Roth IRA directly. Additionally, it also might not be advisable if you’ve contributed mostly pretax funds to your IRAs anyway because the benefit will be limited in terms of both tax liability at the time of the conversion and future distributions.

What is a mega backdoor Roth IRA?

A mega backdoor Roth IRA involves converting your posttax IRA contributions to a Roth IRA within your employer’s retirement plan. This isn’t offered by all employers. Check with your human resources department.

Is a backdoor Roth IRA worth it?

This comes down to your individual circumstances. In general, if you’re opening your first IRA account and you contribute only posttax dollars, converting to a Roth IRA can be advantageous. If you have other IRAs or have contributed significant pretax money, taxes could significantly degrade the benefits.

The Bottom Line: Backdoor Roth Conversions Can Help High-Earners Get Roth IRA Tax Benefits

For those who can’t open a Roth IRA otherwise, a backdoor Roth IRA can be a great way to save for retirement to take advantage of tax-free withdrawals. Even if you have to pay some taxes now, the benefits could be worth it if you’re worried about paying more taxes once you retire.

However, there are drawbacks as well, so make sure you have a complete understanding of how this move might affect your short- and long-term tax implications. If you have any doubts, consult a tax professional.

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