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Thursday, June 08, 2023

What a backdoor Roth IRA is and how to use it

What a backdoor Roth IRA is and how to use it

woman researching IRAs on laptop

Key takeaways

A “backdoor” Roth IRA allows people with high incomes to sidestep the Roth IRA’s income limits. If performed correctly, the backdoor Roth conversion does not have tax consequences.

By
Debbie Macey

04.18.2022

As you’re building your nest egg, Roth options can be valuable.

One of the greatest benefits of a Roth IRA is that qualified investors can enjoy tax-free withdrawals of their money in retirement. A “backdoor” Roth IRA allows people with high incomes to sidestep the Roth IRA’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 nondeductible 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 nontaxable event (unlike if you were to convert pretax 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 to make regular Roth IRA contributions, 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.1

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.

Four easy steps to execute a backdoor Roth IRA

1. Open and make a nondeductible contribution to 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 2023, you can contribute up to $6,500 to a traditional IRA or $7,500 if you’re age 50 or over.2   

2. Research how a Roth IRA conversion works

It might be wise to reach out to a financial professional for help. Consider consulting with a financial professional prior to executing a backdoor Roth conversion.  You may need to include additional tax forms with your annual federal and state tax filings.    

3. Convert your contributions to a Roth IRA

The nondeductible contribution principal amount won’t be taxable as with a normal Roth IRA conversion, but the earnings will be taxable. It may make sense to make the conversion as quickly as possible to minimize taxable earnings.

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 backburner, however, the strategy remains alive and well, at least for now.3

What are the 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 pretax 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 pretax assets. When it comes time to file your tax return, be prepared to pay income tax on the pretax dollars you converted to a Roth. If you have other pretax 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 pretax 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% pretax 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 pretax 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 on a tax-free basis. 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
  • 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 conversion may not fit everyone’s financial strategies and goals. For example:

1. You may not need a backdoor Roth conversion 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. 

2. If you already have pretax money in a traditional IRA, because of the pro rata rule, it may not end up being advantageous from a tax perspective to convert.

3. It’s worth noting that inherited IRAs are not included in the pro rata calculation.

4. You should be willing to keep the funds in the newly created Roth IRA for at least five years before withdrawing the money.

5. 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.

6. 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:

1. You’ve already maxed out other retirement savings options.

2. You are a high-income earner.

3. You’re willing to leave the money in the Roth for at least five years (ideally longer).

4. You do not have other Roth assets.

Suggested next steps for you

Sign up for Empower’s free financial tools to get a complete 360-degree view of your personal finance all in one place. You may also want to consider getting in touch with a financial professional for guidance.

1 IRS.gov

2 Kiplinger, “Roth IRA Contribution Limits for 2022,” May 2022.

3 The Motley Fool, “You Can Still Do a Backdoor Roth in 2022, but You Should Hurry,” January 2022.

4 ThinkAdvisor, “Backdoor Roth IRA Conversions: Beware the Pro Rata Rule,” April 2022.

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Debbie Macey

Debbie Macey

Contributor

Debbie Macey is a Senior Financial Advisor at Empower.

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