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Backdoor Roth IRA

When you consider building your nest egg, Roth options can be extremely valuable.

When it comes to Roth IRAs, one of the greatest benefits is they allow qualified investors to enjoy tax-free withdrawals of their money in retirement. A Backdoor Roth IRA allows people with high incomes to sidestep the Roth’s income limits.

What Is a Backdoor Roth IRA?

A Backdoor Roth IRA essentially lets you convert your nondeductible traditional IRA contribution to a Roth IRA, even if your income is too high to make a Roth IRA contribution. If performed correctly, the Backdoor Roth Conversion does not have tax consequences.

How Does a Backdoor Roth IRA Work?

To make a Backdoor Roth IRA conversion, first you will make a nondeductible contribution to a traditional IRA. Unlike a Roth IRA, the traditional IRA has no income ceiling for contributions.

Then you will convert the nondeductible IRA contribution to your Roth IRA. If there are no earnings on the converted funds, the conversion is a non-taxable event (unlike if you were to convert pre-tax IRA funds into a Roth, in which case you pay taxes on the converted amount at your current ordinary income rate).

An important consideration is your eligibility, based on your Modified Adjusted Gross Income (MAGI) and tax-filing status (single, married filing jointly, married filing separately). This will determine if you are eligible to contribute to a Roth IRA.

If you file taxes as a single person, your MAGI must be under $140,000 for tax year 2022 to contribute to a Roth IRA. (You can contribute fully only if your income is under $125,000. Those with income between $125,000-$140,000 can contribute incrementally less as their income increases.)
If you’re married and file jointly, your MAGI must be under $208,000 for tax year 2022. (You can contribute fully only if your combined income is under $198,000. Those with income between $198,000-$208,000 also have incrementally lower contribution thresholds.)

If your current MAGI exceeds the limit given your tax filing status, you may be able to leverage a Backdoor Roth conversion for your retirement savings.

4 Easy Steps to Execute a Backdoor Roth IRA in 2022

You can perform a Backdoor Roth Conversion by following these four steps:

1. Open and fund a new traditional IRA or contribute to an existing traditional IRA.

You can open an IRA at most financial institutions, both brick-and mortar and online. In 2022 you can contribute up to $6,000 to a traditional IRA or $7,000 if you’re age 50 or over.

2. Research how a Roth IRA conversion works.

It might be wise to reach out to a financial advisor for help here. Consider consulting with a tax professional and your financial advisor prior to executing a Backdoor Roth Conversion.

3. Convert your contributions to a Roth IRA.

The principal won’t be taxable as with a normal Roth IRA conversion, but the earnings will be taxable. So it makes sense to make the conversion as quickly as possible to minimize taxable earnings. Note that if your employer offers a Roth 401k, you can roll over the funds to this if you prefer.

4. Repeat these steps annually.

You can continue to do so for as long as this strategy remains appropriate for your financial situation.

Key Considerations for a Backdoor Roth IRA

Here are some important things to consider before performing a Backdoor Roth IRA.

Are Backdoor Roth IRAs allowed in 2022? The Build Back Better Act would have ended Backdoor Roth IRAs starting in 2022. With this legislation currently on the back burner, however, the strategy remains alive and well, at least for now.
Tax implications of a Backdoor Roth IRA: There might be some instances where you will need to pay taxes with a Backdoor Roth IRA, such as:
If you included pre-tax IRA assets in the conversion. If you deducted your traditional IRA contributions and then decided to convert your traditional IRA to a Roth IRA, you’ll need to pay taxes on the pre-tax assets. When it comes time to file your tax return, be prepared to pay income tax on the pre-tax dollars you converted to a Roth.
If you have other pre-tax IRA assets remaining after your Backdoor Conversion. This is known as the Pro Rata Rule.

The Pro Rata Rule: One of the most important rules relevant to the Backdoor Roth Conversion is the Pro Rata Rule. This is an IRS rule that determines what amount is subject (or not) to taxes when you convert IRA dollars from a traditional IRA to a Roth IRA. To put it simply, if you attempt to convert after-tax traditional IRA contributions to a Roth IRA, but there are existing pre-tax IRA dollars, you will be subject to taxation on a prorated basis.

When determining your tax bill on a conversion from a traditional IRA to a Roth IRA, the IRS is going to look at all of your IRA accounts combined. For example, if all of your IRAs combined consist of 80% pre-tax money and 20% after-tax money, that 80/20 ratio determines what percentage of the after-tax money you convert to a Roth is going to be taxable.

For this specific example, no matter how much money you convert or which pre-tax IRA account you pull the money from, 80% of the amount you convert to the Roth will be taxable. The IRS applies the Pro Rata Rule to your total IRA balance at year-end, not at the time of conversion.

The Five-Year Rule: This rule dictates a five-year waiting period before earnings or converted IRA funds can be withdrawn from the account. To withdraw earnings from a Roth IRA without owing taxes or penalties, you must be at least 59½ years old and have held the account for at least five tax years. If funds are withdrawn earlier, you may have to pay taxes on any earnings and potentially will incur a 10% penalty unless you are age 59½ or older.
Transfers with Backdoor Roth IRAs: Keep in mind that the conversion needs to fall within one of the following options:
A rollover, where you receive funds from your IRA and deposit the money into the Roth account within 60 days;
A trustee-to-trustee transfer, in which the IRA provider sends your funds directly to the Roth IRA provider; or
A “same trustee transfer,” in which both the traditional and the Roth IRA are with the same financial institution.

Is a Backdoor Roth IRA Worth It?

Depending on several factors, the Backdoor Roth IRA limits may not fit everyone’s financial situation. For example:

You may not need a Backdoor Roth IRA if you are able to meet your savings goals with the maximum retirement limit through your workplace retirement account and are not expecting a need for additional savings for your retirement plan.
If you already have pre-tax money in a traditional IRA, because of the pro-rata rule, it may not end up being advantageous from a tax perspective to convert.
It’s worth noting that inherited IRAs are not included in the pro rata calculation.
You should be willing to keep the funds in the newly created Roth IRA for at least five years before withdrawing the money.
You may want to keep the money in the traditional IRA if you are in a high tax bracket now and expect to be in a lower tax bracket upon retirement.
If you plan to relocate to a lower income tax state or a state where there are no income taxes.

On the other hand, a Backdoor Roth conversion can be something to consider if:

You’ve already maxed out other retirement savings options.
You are a high-income earner.
You’re willing to leave the money in the Roth for at least five years (ideally longer).
You do not have other Roth assets.

Suggested Next Steps for You

Get in touch with one of our fiduciary financial advisors in order to get tailored advice on investing practices for your financial goals.
Check out the free guide 65 Ways to Retire Smart, featuring top insights from our financial advisors.
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