The Backdoor Roth IRA: Strategy and Rules

• The backdoor Roth IRA conversion strategy allows high-income earners to contribute to a Roth IRA
• The process involves making a non-deductible Traditional IRA contribution, then immediately converting the contributed amount to a Roth IRA
• A host of rules must be followed, and the process can turn complicated in some scenarios, so knowing the ins and outs is key

High-income earners sometimes don’t have as many retirement savings options as those in lower tax brackets. It takes some strategy to figure out ways to ensure that you are making the most of what’s out there. One tactic is what’s known as the backdoor Roth IRA. The process is actually not too complex so long as all of your financial ducks are in a row. It is dubbed “backdoor” because typical Roth IRA contributions are only allowed if your income is below an annual threshold. 

What is a Backdoor Roth IRA?

A backdoor Roth IRA sounds like a sneaky way to bolster your retirement savings, but it’s a legitimate method to get more money in the Roth bucket. That means your assets can grow tax-free forever if you meet certain requirements. What’s great is that you do not have to open another account – you simply use an existing Traditional IRA and Roth IRA. With a few clicks of a button, you’ll be done. Let’s outline how a backdoor Roth IRA works and when it makes sense.

First, the reason you might have to go the backdoor route to fund a Roth IRA is that the IRS has income limits that disqualify high-income taxpayers from making normal Roth IRA contributions. For a couple, married filing jointly, the 2022 and 2023 income thresholds are $204,000 and $218,000 – if your Modified Adjusted Gross Income (MAGI) is above that level, you are phased out from Roth IRA contribution eligibility. For single filers, the MAGI limits are $129,000 and $138,000 for 2022 and 2023.

The backdoor Roth is a workaround for those pesky limits!

How To Go About a Backdoor Roth IRA

Here’s how it goes: You can use an existing Traditional IRA (or open one if you don’t already have it), then make a non-deductible Traditional IRA contribution and immediately convert that contribution to your Roth IRA. That’s it. 

What’s ideal about this strategy is that there are no income limitations, so even the wealthiest individuals and couples can get some money into a Roth IRA each year, but you must keep to the annual IRA contribution limits. The backdoor Roth play is most used by high earners who also have access to a workplace retirement plan such as a 401(k) or 403(b) since they are typically unable to deduct their Traditional IRA contributions. 

In a perfect world, you would simply open a Traditional IRA, fund it to the 2023 max of $6,500 ($7,500 if you are age 50 or older), then promptly transfer that cash to a new or existing Roth IRA at the same broker. But things are not always so cut and dry. Let’s run through some common possible pitfalls and key rules with backdoor Roth IRA conversions.

Important Considerations

While it is a straightforward process to perform a backdoor Roth IRA conversion, there are some risks. It’s critical that you follow all the rules to avoid penalties and taxes. 

For one thing, if you use an existing Traditional IRA to make your non-deductible contributions, there is what’s known as the pro-rata rule. Since the IRS considers all of your Traditional IRA money in the same bucket when assessing taxes on withdrawals, a problem arises if you wish to convert just some of those assets to a Roth IRA. In this case, which is common, it’s important to work with a financial advisor who can guide you along the process to make sure you avoid excess taxes owed.

Another box to check with a backdoor Roth IRA conversion is that you must file IRS Form 8606 which lists your non-deductible contributions. 

It is easiest to do a backdoor Roth IRA conversion if you have a Traditional IRA and Roth IRA with the same brokerage company, but it’s also possible to execute the strategy if you have different IRA custodians. At worst, you can always have a physical check sent from the brokerage firm handling the Traditional IRA, but the check must be deposited to your Roth IRA within 60 days to avoid owing taxes and an early withdrawal penalty. 

Something else you might be thinking: Why is it important to immediately convert the money? Doing so as soon as possible helps ensure you are not converting much in the way of investment gains, but just your contributions. The thing is, you owe tax on investment growth when doing the Roth IRA conversion, and we do not want that. But if you’re just converting cash, then the urgency is not high, but why not just do it all in one sitting?

Bear in mind that money converted to a Roth IRA must satisfy two 5-year seasoning rules. The first states that you cannot withdraw Roth IRA earnings tax-free unless your initial contribution to the account was made at least five years ago. While you can withdraw Roth IRA contributions at any time free of taxes and penalties, the same is not true for earnings. The other 5-year rule is specific to Roth conversions – converted assets cannot be withdrawn for the first five years after the conversion date, otherwise, you will owe a 10% early distribution penalty.

Finally, you might face state income tax liability on the conversion depending on where you live. And other situations where you take pre-tax retirement assets to move them to be under the Roth umbrella –like rolling over a regular pre-tax 401(k) to a Roth IRA – are taxable transactions.

Even with the rules outlined above, backdoor Roth IRA conversions are common these days, so if you call your brokerage company, they might be able to assist you through some parts of the process, but as soon as you mention issues surrounding taxes, they’ll ask that you speak with a professional specializing in that field. 

When a Backdoor Roth IRA Makes Sense

At a high level, folks in the upper tax brackets stand to benefit the most from the backdoor Roth IRA strategy. While the annual contribution limits are not particularly high for IRAs, doing it every year can lead to significant tax-free assets down the road. Also, once money is in the Roth IRA bucket, you do not have to take Required Minimum Distributions (RMDs) in retirement. 

If you can already make normal Roth IRA contributions or if you may need the money in the next five years, then the conversion process likely does not suit your situation. Also, it simply might not be worth the hassle to execute a backdoor Roth IRA conversion if you have Traditional IRA money due to the complicated pro-rata rule.

The Bottom Line

The backdoor Roth IRA strategy is a workaround way for individuals in a high tax bracket to get more money into their Roth account by making a Traditional IRA contribution and then immediately converting the contributed amount to a Roth IRA. By following the rules, you can set yourself up for years or decades of tax savings.