So you want to contribute to a Roth IRA, but you’re concerned that you’re earning too much… Well, fear not! High-income earners still have the opportunity to funnel money into this awesome retirement account via a method called a backdoor Roth IRA.
It’s a legal tax loophole that allows high earners to contribute indirectly to a Roth IRA.
If you’ve never heard of a backdoor Roth IRA, we’ll talk you through the details. This post breaks down the steps of utilizing this potential tax-saving strategy, as well as other pros and cons to consider.
What is a backdoor Roth IRA?
The “Backdoor Roth IRA” is the process of contributing money to a Traditional IRA, then converting those funds to a Roth IRA. This method is also referred to as a non-deductible IRA, because you are contributing after-tax dollars.
It might sound complex, but don’t worry. It’s actually pretty easy!
This backdoor process avoids the IRS imposed income limits for standard contributions to a Roth IRA. We’ll talk a bit more about those limits below.
How a backdoor Roth IRA works:
In short, you contribute after-tax money into a Traditional IRA. Then, you request a Roth Conversion of those funds, which moves the money from the Traditional IRA to the Roth.
Because you’re converting money that you’ve already paid taxes on, this conversion is not a taxable event. The whole point of a Roth is to forgo any tax breaks upfront. Instead, you’ll benefit from tax-free growth and withdrawals later in life.
To be clear, a backdoor Roth IRA is not a type of retirement account. You won’t see this as an option when you login to your Fidelity account. It’s a process. It’s really just a method of moving funds around to funnel money into a Roth IRA that you otherwise wouldn’t be able to sock into that account.
Who should use a backdoor Roth IRA?
In 2023, a single person must make less than $153,000 per year, and a married couple (filing jointly) need to earn under $228,000 annually to contribute directly to a Roth IRA.
So, the backdoor Roth IRA method is for any folks who are in the fortunate position of making more than that. This process let’s you sneak around the limits and get money into a Roth. And it’s 100% legal.
It’s important to note, there are also contribution limits for IRAs each and every year. Both traditional AND Roth IRAs have a maximum amount that you can put in each year, and that amount is across both accounts.
In 2023, the total contribution limit is $6,500 (or $7,500 if you are age 50 or older).
What about taxes?
Usually, when you fund a traditional IRA, you are claiming those contributions as tax deductions on your annual return. The goal is to defer paying taxes on that money until you withdraw it later in retirement.
But when using a backdoor Roth IRA method, you’re making after-tax contributions to begin with. Paying taxes on that money now ensures that you can convert it to a Roth without penalty. Because you’re forfeiting the tax break upfront, you’ll benefit from the Roth advantages of both tax free growth and tax free withdrawals later in life.
Keep in mind, when performing a backdoor Roth IRA conversion, you’re still on the hook to pay taxes on any money in your traditional IRA that wasn’t previously taxed. If you convert any pre-tax funds, you’ll owe taxes on that amount.
For example, if you contribute $5,000 to a traditional IRA, claim a deduction for the $5,000 on your tax return, and then convert that money to a Roth IRA, you’ll owe taxes on the $5,000. Ultimately, there’s no escaping the IRS… Taxes must be paid one way or another, either now or later.
Also of note – conversions could bump you into a higher tax bracket. You must adhere to a five-year aging rule in order to be eligible for tax-free distributions (see Risks section below).
Benefits of a backdoor Roth IRA
There are several benefits to considering a backdoor Roth IRA. Here are some of the most notable:
- Roth IRAs don’t have required minimum distributions (RMDs). Regular IRAs do. So there’s a lot more flexibility later in life with money that you’ve invested in a Roth IRA vs. a traditional IRA.
- Spreading your money across pre-tax and post-tax buckets gives you more withdrawal options later in life. It allows you to essentially choose your tax bracket each year.
- Assuming you’ve met the 5 year rule, contributions to a Roth IRA can be withdrawn anytime, without penalty or tax. This is a significant advantage to folks retiring before age 59 ½.
- Perhaps the best advantage of a backdoor Roth IRA is that you pay taxes upfront. Everything after that is tax free. This is most ideal if you believe that tax rates will rise in the future, or that you’ll be in a higher bracket later than you are now.
Risks of a backdoor Roth IRA
Despite all the potential benefits to executing a backdoor Roth IRA, there are some drawbacks that should be taken into consideration before hitting the GO button:
- If you end up needing the money you’ve contributed to the backdoor Roth within the next five years, you’ll have to pay a 10% penalty to withdraw it.
- The process can become complex if you have too many IRA accounts, and you’re not a detail oriented person. Making mistakes in the process may cause costly tax errors. (If this is the case for you, seek out a financial planner or tax pro for assistance.)
- There’s a pro-rata rule to consider if you have both pre-tax AND post-tax contributions in the same IRA. If you’re unaware of how to determine your tax liability, you’ll need to work with an advisor before making changes that could cause tax issues.
- You could end up paying more in taxes if you’re simultaneously converting a 401(k) AND a traditional IRA, to a Roth IRA. It’s no fun to get pushed up into a higher tax bracket. Which is why it’s so important to plan out your Roth conversion ladder.
The bottom line:
If you make too much to contribute to a Roth IRA, or have determined that a Roth IRA is preferable for your retirement, the backdoor Roth IRA method is how you’re able to (legally) sneak $6,500 into that account.
If you’re considering employing the backdoor Roth IRA technique, do the math and think about the tax ramifications. Especially if you’re converting the entire balance of a traditional IRA. You could end up owing a lot of taxes to Uncle Sam if you’re not careful.
No matter how you dissect it, it’s probably a good idea to protect your nest egg from future tax increases that we think are inevitable. But if you are unsure about the tax implications, consider consulting with a tax professional first.
Related posts:
