High-income earners aren't permitted to contribute directly to a Roth IRA but they can still make contributions indirectly thanks to a tax loophole known as the backdoor Roth IRA. You can potentially save tens of thousands of dollars in taxes over the years and maximize your retirement savings if you take advantage of it.
Key Takeaways
- High-income earners who can’t contribute directly to a Roth IRA may be able to contribute indirectly via a backdoor Roth and maximize their retirement savings.
- Roth IRAs are attractive because they don’t have required minimum distributions (RMDs) and their distributions are tax-free.
- The lack of RMDs from Roth IRAs also simplifies the record-keeping and tax preparation processes.
- A backdoor Roth can be created by first contributing to a traditional IRA and then immediately converting it to a Roth IRA to avoid paying taxes on any earnings or having earnings that put you over the contribution limit.
- A backdoor Roth IRA may not be the best idea for those who expect to need the money they’re contributing to the backdoor Roth in the next five years.
Why Bother With a Backdoor Roth IRA?
Both Roth and traditional IRAs let your money grow within the account tax-free but Roth IRAs have a couple of advantages over traditional IRAs.
They don’t have required minimum distributions (RMDs). You can leave your money in your Roth for as long as you like. It can keep growing indefinitely. This characteristic may be valuable to you if you expect to have enough retirement income from another source, such as a 401(k), and you want to use your Roth as a bequest or an inheritance.
The lack of RMDs also simplifies record-keeping and makes tax preparation easier. It will save you time and headaches in retirement when you’d rather be enjoying your free time.
Roth distributions, including earnings on your contributions, aren't taxable, subject to a few qualifying rules. Future tax rates may be higher than current tax rates so some people would rather pay taxes on their retirement account contributions, as one does with a Roth, than on their distributions, as one does with a traditional IRA or 401(k). Other people want to hedge their bets by making both pre-tax and post-tax contributions so they have a position in both options.
How to Create a Backdoor Roth IRA
There are income requirements for Roth IRA contributions. Single taxpayers with modified adjusted gross incomes (MAGIs) of at least $146,000 in 2024 have lower Roth IRA contribution limits. They can’t contribute at all if they earn more than $161,00 a year in 2024.
Married taxpayers are further disadvantaged because their limits aren’t double those for single filers. The phase-out range is $146,000 to $161,000 for single filers in 2024 and $230,000 to $240,000 for married couples filing jointly.
A traditional IRA doesn’t limit or prevent people with higher incomes from contributing. The backdoor Roth takes advantage of this.
Step 1: Contribute to a Traditional IRA
You can contribute the amount of your earned income or $7,000 to a traditional IRA in 2024, whichever is less. A working spouse can also contribute for a non-working or low-earning spouse provided that both spouses’ combined contributions don’t exceed their combined incomes.
Individuals who are age 50 or older can make an extra $1,000 in catch-up contributions each year. A married couple could each put $8,000 in a traditional IRA in 2024 for a total of $16,000 provided that each spouse is at least 50.
Your income is too high to deduct your traditional IRA contributions from your tax bill if it's also too high to contribute to a Roth and you or your spouse also contribute to a retirement plan at work. You would be putting after-tax dollars into your traditional IRA in this situation.
Step 2: Immediately Convert Your Traditional IRA to a Roth IRA
You could have earnings if you leave the money in your traditional IRA for too long. You'll have to pay tax on those earnings when you do your conversion.
You’ll have an excess contribution that you must correct by paying taxes if you accumulate enough earnings and then convert your entire account balance. Any untaxed amounts in the traditional IRA will result in taxation after the conversion. Keep life simple and don’t procrastinate.
Step 3: Repeat the Process If You Wish
You can take advantage of the backdoor Roth each year in which you can’t fully contribute to a Roth IRA by the regular, front-door way,
You must begin taking required minimum distributions (RMDs) from a traditional IRA by age 73.
Follow the Rules
You’ll want to ensure that you abide by IRS rules for your Roth IRA. Four tips will help you make sure you do:
- Follow the pro-rata rule if you already have a traditional IRA into which you've made tax-deductible contributions. The easiest way to avoid dealing with this rule is to maintain a zero balance in all traditional IRAs, SEP IRAs, and SIMPLE IRAs.
- Don’t remove the converted funds from your Roth IRA for at least five years if you're younger than age 59½. You'll have to pay a 10% penalty if you remove the money sooner unless you qualify for one of the limited exceptions.
- Don’t let your backdoor contribution fall into your own hands between contributing it to a traditional IRA and moving it to a Roth IRA. You could end up with an unexpected tax bill. Do a trustee-to-trustee transfer if your traditional and Roth IRAs aren't at the same financial institution or a same-trustee transfer if both IRAs are at the same institution.
- Fill out IRS Form 8606, Nondeductible IRAs, when you file your tax return.
When to Avoid a Backdoor Roth IRA
A backdoor Roth IRA isn't a good choice for everyone. It's bound to backfire if you don't know the basics. There are some circ*mstances under which it might not be a good idea to set up a backdoor Roth yourself:
- You expect to need the money you contribute to the backdoor Roth in the next five years. You'll have to pay a 10% penalty if you withdraw it before the five-year period has passed.
- You aren't confident that you can manage the process correctly and avoid any costly tax errors. Ask a financial planner or tax advisor for help if this is the case.
- You think the pro-rata rule applies to your situation but you don't understand how to do the math to calculate your tax liability. Again, this is a DIY problem so ask a professional for help.
What Is a Backdoor Roth IRA?
A backdoor Roth IRAisn't an official retirement account. It's a tax strategy that's allowed by the IRS. It allows you to fund a Roth IRA even when your income exceeds the maximum set by the IRS.
How Does a Backdoor Roth IRA Work?
A taxpayer first makes contributions to a traditional IRA account. That account is then immediately converted to a Roth IRA. This allows the individual to avoid paying any taxes on earnings provided they meet certain rules. You can repeat the process yearly if your income doesn't allow you to contribute to a regular Roth IRA.
Is a Backdoor Roth IRA Worth It?
Yes. Roth IRAs don't have required minimum distributions so you can leave your money in the account and let it grow. And the money you do withdraw generally isn't taxable. You pay tax on the contributions at the time you make them but not the distributions, subject to some rules. Earnings are subject to taxes if you leave the money in a traditional IRA. Just make sure you know the rules so you don't end up paying more than you save.
How Much Can You Backdoor Into a Roth IRA?
You can contribute the lesser of your earnedincomeor $7,000 to a traditional IRA in 2024, which you can then convert to a backdoor Roth IRA. You can also make an additional catch-up contribution of $1,000 each year if you're age 50 or older.
The Bottom Line
Contributing to a Roth IRA through the back door is more complicated than contributing the straightforward way but it’s your only option if your income exceeds IRS limits. It’s worth the extra steps for many people because a Roth has extra tax benefits that a traditional IRA does not. Consult with a financial planner or tax advisor for help executing your backdoor Roth IRA contribution correctly,
Correction–April 18, 2024: This article has been updated to correct the assertion that converting a 401(k) balance into a Roth IRA would result in extra taxes. The IRS does impose a one-per-year limit on some rollover transactions but the limit doesn't apply to plan-to-IRA rollovers.
