The Backdoor Roth IRA Explained

Roth IRAs are among the most valuable retirement accounts available. They offer tax-free growth and tax-free qualified withdrawals in retirement, and they don’t require minimum distributions during the original owner’s lifetime. But there are income limits for contributing directly to a Roth IRA, which prevent many high earners from contributing. The backdoor Roth IRA is a common, legal workaround that allows high earners to get money into a Roth IRA.

Why Roth IRAs are valuable

With a Roth IRA, you contribute money you’ve already paid taxes on. In exchange, qualified withdrawals in retirement, including all investment growth, are tax-free. Qualified withdrawals generally require that you’re at least 59½ and that the account has been open for at least five years.

Roth IRAs offer tax diversification in retirement, flexibility, since contributions can generally be withdrawn at any time, and estate planning benefits, since heirs can generally receive tax-free distributions.

However, the ability to contribute directly to a Roth IRA phases out at higher income levels, and people with incomes above the upper threshold can’t contribute directly at all. Income limits are adjusted periodically, so check irs.gov for current amounts.

How the backdoor Roth works

The backdoor Roth takes advantage of the fact that there’s no income limit on contributing to a traditional IRA, although the ability to deduct contributions may be limited, and there’s no income limit on converting a traditional IRA to a Roth IRA.

The process generally involves three steps. First, contribute to a traditional IRA. At higher incomes, especially if you’re covered by a workplace retirement plan, this contribution is usually nondeductible, meaning you don’t receive a tax deduction for it. Second, convert the traditional IRA to a Roth IRA. Many people convert shortly after contributing. Third, pay any tax due on earnings before the conversion. If you convert quickly, there’s often little or no growth, so little or no tax is due.

There’s no income limit on Roth conversions, which is what makes this strategy possible. Because the original contribution was made with after-tax money, it isn’t taxed again when converted.

The pro-rata rule

The pro-rata rule is the biggest trap in the backdoor Roth strategy. If you have other pre-tax money in any traditional, SEP or SIMPLE IRA, the IRS generally treats all of your IRAs as one combined account when calculating the tax on a conversion. Your conversion is treated as coming proportionally from both pre-tax and after-tax money, regardless of which account you convert from.

That means part of the conversion could be taxable, potentially significantly reducing the benefit of the strategy.

The pro-rata calculation uses your total IRA balances as of December 31 of the year you convert, not just at the time of conversion. Rolling pre-tax IRA money into a workplace plan, such as a 401(k), before year-end can remove it from the pro-rata calculation, since workplace plans aren’t included. Check whether your employer’s plan accepts incoming rollovers.

Your spouse’s IRAs aren’t included in your pro-rata calculation, since IRAs are individual accounts.

Paperwork and record-keeping

Report nondeductible contributions to traditional IRAs and Roth conversions on IRS Form 8606, which you file with your tax return. Form 8606 tracks your basis, the after-tax money in your IRAs, which determines how much of future conversions or distributions is taxable. Keep careful records of contributions, conversions and Form 8606 filings, since errors can lead to paying tax twice on the same money.

Your IRA custodian will send Form 1099-R reporting the conversion.

Timing considerations

Many people convert soon after contributing to minimize taxable earnings. Some advisers have historically suggested waiting a short period between contributing and converting, though recent IRS guidance and practice have generally accepted the strategy.

Each conversion has its own five-year period for determining whether converted amounts withdrawn before age 59½ are subject to a penalty, which matters if you might need the money before retirement.

The backdoor Roth versus the mega backdoor Roth

The standard backdoor Roth IRA is limited to the annual IRA contribution limit. The mega backdoor Roth, a different strategy using after-tax contributions in a 401(k) plan that allows them, can enable much larger Roth savings. Some high earners use both strategies.

Is the backdoor Roth right for you?

A backdoor Roth can make sense for high earners who want more tax-free retirement savings, especially those who have already maximized other tax-advantaged accounts, such as 401(k)s and health savings accounts. It’s particularly attractive for people who don’t have pre-tax IRA balances, avoiding the pro-rata complication.

Consider your expected tax bracket in retirement, your other retirement savings and whether you have pre-tax IRA money that would complicate the strategy. Talk with a tax professional to make sure it fits your situation and that you file the necessary forms correctly.