What is a Back Door Roth and Who Needs It
Melanie DJ • 7 March 2023
If you want to take advantage of the many benefits of a Roth IRA but make to much to do so, the backdoor Roth IRA conversion offers a workaround.
Roth IRA's boast many benefits, including tax-free growth on your investments and tax-free withdrawals in retirement. Consequently, the Roth IRA is an attractive investment vehicle for those who want to mitigate their tax burden. Additionally, unlike a Traditional IRA, the Roth IRA does not have an RMD requirement or penalty for early withdrawals.
However, the IRS imposes income limits on who can contribute to a Roth IRA. Because of this, the backdoor Roth is a great option for those who would like to take advantage of Roth benefits, but don't qualify to contribute to one.
What is a Backdoor Roth?
High-income earners are barred by the IRS from contributing directly to a Roth IRA. However, the backdoor Roth is a specific strategy that is used to convert Traditional IRA contributions to Roth IRA contributions by putting money into a Traditional IRA post-tax, then immediately converting the account to a Roth IRA.
Who Needs a Backdoor Roth?
Whether or not you need a backdoor Roth is related directly to your modified adjusted gross income (MAGI) in the year the contributions are made. The table below outlines these income restrictions.
| FILING STATUS | 2023 MODIFIED AGI | ALLOWED CONTRIBUTION |
|---|---|---|
| Married Filing Joint | < $218,000 | $6,500 |
| Married Filing Separately | < $10,000 | Reduced Amount |
| Single / Head of Household | < $138,000 | $6,500 |
If your modified adjusted gross income (AGI) exceeds the amounts defined in the table above, you may be able to contribute a reduced amount until you reach the phase-out income. Once your income exceeds the phase out level, you may not contribute anything to a Roth IRA.
How to Complete a Backdoor Roth Conversion
In short, to complete a backdoor Roth conversion you must first fund a Traditional IRA, then rollover the funds to a Roth IRA and likely pay taxes on the conversion. Or, you can make nondeductible contributions to a Traditional IRA and rollover the funds to a Roth IRA without paying taxes upon conversion since you put the money into the Traditional IRA after-tax.
Here's how to do it step by step:
- Open a Traditional IRA. If you don't already have one, consult a financial advisor. On the other hand, if you do have a Traditional IRA with funds in it already, you can convert the funds held in it to a Roth. However, keep in mind you'll have to pay taxes upon conversion of these funds, since you likely put the funds in the account pre-tax.
- Fund the IRA with non-deductible contributions. This means you put money into the IRA after-tax, and you do not seek any tax deductions for contributions in the year contributed. While typically a Traditional IRA is funded with before-tax dollars, making after-tax contributions to it will save you the extra step at the end of the year of paying taxes upon converting to the Roth.
- Communicate with IRA company, financial advisor, and/or HR department of your intent to make a conversion. Your IRA administrator or brokerage firm should give you instructions and paperwork to authorize the conversion.
- Make the conversion and pay any required taxes. If you fund your Traditional IRA with non-deductible contributions (after-tax contributions) and immediately convert it to a Roth, you shouldn't owe any taxes. On the other hand, if you are converting an existing Traditional IRA with deductible contributions in it, you'll owe taxes upon conversion.
A word of caution: if you are rolling over an existing Traditional IRA or 401(k) with pre-tax dollars in it, calculate the taxes you'll owe before making the conversion. You could end up with a hefty tax bill depending on how much you have in the account. Also keep in mind that ALL employer matching contributions are considered pre-tax, and therefore will always be taxed upon a rollover Roth conversion.
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Rolling Over Funds vs Converting Funds
Maybe you're wondering why I keep using two different terms: rollover and conversion. Both refer to the transfer of funds from one retirement account to another, but the methods of transfer are different.
Specifically for a Traditional IRA or 401(k) to Roth transfer, a rollover refers to taking pre-tax Traditional funds from an existing Traditional IRA or 401(k) account and rolling them into a Roth IRA.
A Traditional to Roth conversion typically refers to moving after-tax Traditional funds from a Traditional IRA you recently set up, and immediately converting the Traditional account to a Roth account.
Got it? ;) Confusing, I know. Don't fret, a financial advisor can help you with this.
Roth IRA Benefits
Roth IRA's boast some major advantages over a Traditional IRA, the biggest being how and when the money in a Roth is taxed. Simply put, a Roth IRA allows you to grow your investment tax-free and enjoy tax-free withdrawals in retirement!
Below are notable perks of a Roth IRA or 401(k):
- Withdrawals in retirement are tax-free
- Earnings on contributions grow tax-free
- No required minimum distributions at a certain age, unlike the traditional IRA
- You can contribute to your Roth IRA past normal retirement age (subject to income limitations)
- If applicable, beneficiaries that inherit your account will also receive money tax-free
For the majority of people a Roth IRA is preferred over a traditional IRA, especially if you expect your income to increase over time. It's always a good idea to consult your financial advisor and determine what's best for your unique situation.
Backdoor Roth Planning Considerations
While a backdoor Roth can be beneficial in many situations, here are a few things to consider before taking action:
- A backdoor Roth conversion can trigger a significant tax burden if you are rolling over an old account. If you will have to take a distribution of your retirement funds to cover the taxes, you might want to reconsider.
- The five-year rule: Roth IRA accounts need to be open a minimum of five years to make tax-free withdrawals without penalty. If you will need the funds sooner, you might want to keep the money where its at.
- Tax ramifications in year of conversion could push you into a higher tax bracket. Not only will you have to pay the taxes on the money you convert, but depending on how much you withdraw, you could push yourself into a higher tax bracket. You want to avoid this if possible. Consult with your tax profession to determine the best course of action.
I can't stress this enough- consult with your tax professional and financial advisor when making investment decisions that have tax implications. You want to ensure that the benefits outweigh the costs before taking action!
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