What Is a Backdoor Roth IRA?
A “Backdoor Roth IRA” is not an official type of IRA. Instead, it is an informal name for a complicated method generally used by high-income taxpayers to create a permanently tax-free Roth IRA, even if their incomes exceed the limits that the tax law prescribes for regular Roth ownership.
Keep in mind that this is not a tax dodge. When you transfer the assets of a traditional IRA to a Roth IRA, you owe taxes in that tax year on any funds—as well as on earnings and appreciation in transferred assets—that have not been taxed previously. If the IRA has been funded solely with tax-deductible contributions, the entire value of the transferred assets will be taxed. However, as with any Roth IRA, if you follow the rules, then you should owe no further taxes when you withdraw that money.
Understanding Backdoor Roth IRAs
A Roth IRA allows taxpayers to set aside a few thousand dollars from their earnings every year in a retirement savings account. The contributed money is after-tax dollars. That is, the funds are earnings that have been taxed in the year when they are contributed to the Roth IRA.
A Roth IRA differs from a traditional IRA. The traditional IRA gives the earner an immediate tax break because taxpayers can take a tax deduction for their contributions in the year they are made and no taxes are due until the money is withdrawn. When withdrawals are made, usually after the retirement, the account holder will owe taxes on both the dollars invested and their earnings.
In some cases, taxpayers whose high incomes or coverage by an employer retirement plan make them ineligible to deduct IRA contributions, contribute after-tax funds to an IRA.
The problem for high income taxpayers is that individuals who earn above a certain amount aren’t allowed to open or fund Roth IRAs—under the regular rules, anyway. Once your annual income exceeds a specified threshold, you cannot participate at all.
Traditional IRAs don’t have income ceilings for participation. And, since 2010, the IRS hasn’t had income limits that restrict who can convert a traditional IRA to a Roth IRA. As a result, the Backdoor Roth IRA has become a tax-planning opportunity for higher-income taxpayers who ordinarily couldn’t contribute to a Roth IRA
How to Create a Backdoor Roth IRA
You can create a Backdoor Roth IRA in one of 3 ways:
Contribute money to an existing traditional IRA and then roll over the funds to a Roth IRA account.
Convert your entire traditional IRA account to a Roth IRA account.(Pro Rata Rules Apply)
If your company 401(k) plan allows conversions, you can roll your 401(k) account over to a Roth IRA.
Tax Implications of a Backdoor Roth IRA
Keep in mind that in an conversion to a Roth IRA, you still need to pay taxes on any money in your traditional IRA that hasn’t already been taxed. For example, if you contribute $6,000 to a traditional IRA, claim a deduction for the $6,000 on your tax return, and then convert that money to a Roth IRA, you’ll owe taxes on the $6,000. You’ll also owe taxes on whatever money that IRA contribution earned between the date it was contributed to the traditional IRA and the date you converted it to a Roth IRA.
If you make after-tax contributions to a traditional IRA—that is, contribute funds that are non-deductible and taxable that year—such amounts will not be taxed on their transfer to the Roth IRA. But if most of your IRA contributions were deducted from your income, and if your IRA has accumulated earnings or made investments that have appreciated over a long period, most of the funds and investments that you convert to a Roth IRA will likely count as taxable income at the time of the conversion and could kick you into a higher tax bracket in that year.
Also, the funds that you put into the Roth are considered converted funds, not contributions. That means you have to wait five years to have penalty-free access to your funds in your Backdoor Roth IRA if you’re under the age of 59½. Such converted funds differ from regular Roth IRA contributions, which can be withdrawn at any time without taxes or penalties.
On the positive side, a Backdoor Roth IRA lets you get around the income and contribution limits that apply to traditional Roth IRAs
Advantages of a Backdoor Roth IRA
Aside from getting around the limits, why would taxpayers want to take the extra steps involved in doing the Backdoor Roth IRA dance? There are a number of good reasons.
For one thing, Roth IRAs don’t have required minimum distributions (RMDs), which means account balances can create tax-deferred growth for as long as the account holder is alive. You can take out as much or as little as you want, when you want, or you can leave it all for your heirs.
Another reason is that a Backdoor Roth contribution can mean significant tax savings over the decades because Roth IRA distributions, unlike traditional IRA distributions, are not taxable.
The main advantage of a Backdoor Roth IRA—as with Roths in general—is that you pay taxes upfront on your converted pre-tax funds and everything after that is tax-free.
The Bottom Line
If you’re thinking of creating a Backdoor Roth IRA, crunch the numbers and carefully consider the pros and cons, especially if you are converting the entire balance of a traditional IRA or if you have multiple IRAs and are subject to Pro Rata Rule.