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Updated on Monday, January 6, 2020
A backdoor Roth IRA is a tax strategy that can help make your retirement portfolio as efficient as possible. A regular Roth IRA can help boost your retirement savings with tax-free growth, but this type of individual retirement account is not available for people with incomes above certain thresholds. If your income is too high for a regular Roth IRA, check out the backdoor Roth IRA strategy.
“A backdoor Roth IRA is the unofficial term for a method higher-income earners can use to deposit money into a Roth account,” said Kevin Gains, chief investment officer at American Financial Management Group in Berwyn, Pa. “The IRA owner makes a non-deductible contribution to a traditional IRA, then does a Roth conversion of the amount into his or her Roth IRA.”
How does a backdoor Roth IRA work?
A backdoor Roth IRA is a way to convert tax-deferred IRA assets into tax-free ones for people who wouldn’t otherwise be able to save in a regular Roth IRA. The process is pretty straightforward, but there are some important rules you need to know to make this strategy work for you.
Money you add to a Roth IRA can be withdrawn tax-free in retirement, which comes in handy if you expect to be in a higher tax bracket once you retire. Traditional IRAs are available for everyone, no matter how much income you make. However, direct contributions to a Roth IRA are only available to people who make under certain thresholds.
For 2019, you can make the full $6,000 annual contribution to a Roth IRA if you have a modified adjusted gross income (MAGI) of less $122,000 as a single filer or less than $193,000 if you’re married and file a joint return. Contributions are reduced once you pass those income thresholds. They phase out entirely for single filers making more than $137,000 or married couples filing jointly who earn more than $203,000.
How do you set up a backdoor Roth IRA?
There are two components involved in setting up a backdoor Roth IRA: a nondeductible IRA and a Roth IRA. With a traditional IRA, you deduct contributions from your taxable income for the year if you’re under certain income thresholds. If you’re above those thresholds, you can still make contributions, but you can’t claim any tax deduction deductions for them — these are referred to as nondeductible IRA contributions.
According to Andy Panko, owner and financial planner at Tenon Financial in Iselin, N.J., the mechanics of a backdoor contribution are fairly simple.
“First, you need to make a contribution to a traditional IRA,” Panko said. “However, that contribution needs to be after-tax, not a deductible contribution like most contributions to traditional IRAs.”
Once you make a nondeductible contribution to a traditional IRA, you can start the second part of the backdoor Roth IRA process. This is where you convert the nondeductible IRA to a Roth IRA, also known as a “Backdoor Roth Conversion.”
“To actually do the conversion, all you need to do is contact the custodian of your traditional IRA and tell them you want to convert it to a Roth IRA,” Panko added. This assumes that you’ve already opened a Roth account; if you haven’t, you’ll need to do that first.
How much can you contribute to a Backdoor Roth IRA?
The maximum annual contribution you can make to a backdoor Roth IRA is the same as the annual limit for a traditional IRA. For 2019, the maximum contribution to a traditional IRA is $6,000. You can tack on an additional $1,000 if you’re age 50 or older as a catch-up contribution. Those limits are the same for the 2020 tax year.
It’s also possible to move all of your existing traditional IRA assets, or all the assets you have in an employer’s 401(k) plan, into a Roth account. This is typically referred to as a Roth conversion, since you’re making all the money in a pre-tax account after-tax.
If you want to convert your traditional IRA or 401(k) to a Roth IRA, there are three ways to do it:
- Rollover. Your IRA or 401(k) administrator cuts you a check for the balance in your account and you then have 60 days to deposit it into a Roth IRA.
- Trustee-to-trustee transfer. You tell the financial institution that holds your traditional IRA or 401(k) balance to transfer the money into a Roth IRA at another brokerage or investment firm.
- Same trustee transfer. You have traditional IRA assets moved into a Roth IRA at the same financial institution.
If you’re rolling traditional IRA or 401(k) assets over yourself, there’s one important caveat to note. You have to deposit the check issued to you for your account balance into a Roth IRA within 60 days; otherwise, the entire amount is treated as a taxable distribution. If you’re under age 59½ at the time, the 10% early withdrawal penalty also kicks in.
Retirement benefits of a backdoor Roth IRA
Including a backdoor Roth IRA in your retirement strategy can pay off in more ways than one.
“There are four main benefits of a backdoor Roth IRA,” said Derek Mazzarella, a financial advisor with The Bulfinch Group in Needham, Mass. The first and most obvious benefit is being able to make Roth contributions if your income ordinarily wouldn’t allow it — that means more tax-free income in retirement.
Beyond that, Mazzarella noted, savers benefit from having a source of tax-free income they can tap into in retirement. That can help when it comes to applying for Social Security benefits or Medicare.
“Costs of medicare and taxation of Social Security are based on income in retirement,” he said. “Roth income does not factor into the calculation of income toward those two items so as a result, a person may pay less for Medicare and/or a smaller percentage of their Social Security benefits may be deemed taxable.”
Finally, keeping retirement assets in a Roth IRA allows you to avoid having to take required minimum distributions (RMDs). These distributions are required beginning at age 70 ½ if you have assets in a traditional IRA or 401(k) in retirement. The amount you’re required to withdraw is based on life expectancy and your account balance.
Failing to take RMDs on schedule can result in a tax penalty of 50% of the amount you were required to withdraw. Assuming you complete a backdoor Roth IRA before you turn age 70½, you’d be able to sidestep the RMD rule and leave the money in your account indefinitely. In fact, no withdrawals would be required from a Roth IRA until you pass away, in which case it would be up to your beneficiary to decide what to do with the money.
Tax Rules for Backdoor Roth IRAs
Completing a backdoor Roth IRA is the easy part — it’s managing the tax implications that can get tricky.
If you make a nondeductible traditional IRA contribution and immediately convert it to a backdoor Roth, you wouldn’t owe any taxes. On the other hand, if you convert all of your traditional IRA assets to a Roth account, the entire amount would be subject to federal income tax if you made deductible contributions.
The pro rata rule
The pro rata rule can make things a little murkier if you have multiple traditional IRAs but you’re not converting all of those assets to a Roth account.
“Under this rule, the withdrawals are treated as a combination of the nondeductible contribution and the existing balance,” Gains said. “In most cases, this results in the conversion being mostly taxable, which defeats the whole idea of the backdoor Roth.”
Under the pro rata rule, the IRS requires you to calculate the percentage of the amount that’s being converted in all your tax-deferred IRAs. A separate aggregate rule means that all of your traditional IRAs — including SEP IRAs or SIMPLE IRAs — must be combined when making your pro rata calculation.
Here’s how the formula works:
- Add up the amount of after-tax dollars in all your traditional, SEP and SIMPLE IRAs, including nondeductible contributions, repaid reservist distributions or rollovers of after-tax dollars from a qualified retirement plan.
- Divide that amount by the total balance of all your traditional IRAs combined, as of the last day of the most recent year.
- Multiply that number by the amount of all traditional IRA distributions being taken.
The remaining number is the amount you’ll be able to convert to a backdoor Roth IRA tax-free. The rest is subject to ordinary income tax. Panko offers an example of how the pro rata and aggregate rules work in action.
Pro rata rule example
Assume you have a traditional IRA which already has $95,000 of tax-deferred money. You make a $5,000 nondeductible contribution as the first step in a backdoor Roth IRA contribution, making your traditional IRA balance $100,000.
If you divide $5,000 by $100,000, you get 5%, which represents the percentage of the $5,000 nondeductible contribution that’s tax-free. That means $250 of your money is tax-free; the remaining $4,750 is subject to tax at your ordinary income tax rate.
“Unfortunately, when converting you can’t pick and choose which specific dollars get converted,” Panko said. “The IRS forces you to pro rate each conversion between pre-tax and after-tax money.”
The upside is that you’re only increasing your tax liability temporarily. You’d have to pay taxes on the amount being converted for the tax year in which you convert them. After that, the now-converted money in your Roth account would be tax-free once you begin making qualified withdrawals.
Who Is a Backdoor Roth IRA Right For?
Whether you should use a backdoor Roth IRA for retirement depends largely on your goals for managing taxes and time horizon.
“You want to make sure you’re aware of what tax bracket you’re converting funds in,” Mazzarella said. “If you’re in the highest tax bracket, it may not make sense to convert a traditional IRA to a Roth IRA.”
The upfront deduction associated with traditional IRA contributions could prove more valuable in the near term than tax-free distributions later if you expect to be in a lower tax bracket at retirement.
Panko said it’s important to be aware of how much money you have in your traditional IRAs and how much of that is tax-deferred, when determining your tax liability using the pro rata rule. That’s important because you’ll need to make sure you have the cash on hand to pay your taxes owed in the year you make the transition from traditional to Roth assets.
That being said, a backdoor Roth IRA could be the right move if your income is too high for Roth contributions and you’re willing to trade paying taxes today to avoid taxation in retirement, Gains said.