Both traditional and Roth IRAs are retirement accounts that make saving for retirement more manageable. The problem, however, that some may face is the income limit put in place that limits who can contribute to a Roth IRA. For tax year 2021, single filers making over $140,000 and married couples (filing jointly) making over $208,000 annually are ineligible to contribute to a Roth IRA.
Although high-income earners may not be able to contribute directly to a Roth IRA, they can utilize what's commonly referred to as a "backdoor Roth IRA." A backdoor Roth IRA isn't an official retirement account; it's a method used to get around the Roth IRA income limit.
1. Creating a backdoor Roth IRA is about converting accounts
Creating a backdoor Roth IRA can be done in two general steps:
- Contribute to a traditional IRA account: Luckily, traditional IRAs don't have an income limit, so anyone is eligible to contribute to it. If you already have a traditional IRA, simply contribute to it. If you don't currently have one, you can open an account and contribute your desired amount.
- Convert your traditional IRA to a Roth IRA: Once you've contributed the desired amount to your traditional IRA, reach out to your IRA plan provider and inform them you want to convert funds to a Roth IRA. This process may look different for different IRA plan providers, so it's important to check with your plan administrator. If you don't currently have a Roth IRA, you'll open one during conversion.
Once you've successfully converted funds from a traditional to a Roth IRA, you'll want to begin preparing for the tax implications of this move.
2. You'll owe taxes on backdoor Roth IRAs
One of the key benefits of a traditional IRA is that your contributions are tax-deductible. The amount you're eligible to deduct depends on if you or your spouse are covered by a retirement plan at work. Roth IRAs, on the other hand, are meant to be funded with after-tax money. So, if you deduct your traditional IRA contributions and then decide to convert them to a backdoor Roth IRA, you'll likely be subjected to income taxes.
For example, if you contributed $6,000 to a traditional IRA -- the max allowed for tax year 2021 if you're under 50 years old -- and then converted the money to a Roth IRA, you'd owe income taxes on the $6,000, as well as any money it earned between the time of contribution and conversion.
Also, keep in mind that conversions to Roth IRAs have different withdrawal rules than contributed funds. You can withdraw any contributions -- but not earnings -- from a Roth IRA at any time without facing penalties. Funds converted to a Roth IRA must be kept there at least five years (if you're younger than 59 ½ years old) to be withdrawn penalty-free.
3. The IRS uses the pro-rata rule
After creating a backdoor Roth IRA, the IRS will calculate the exact amount of your tax bill pro-rata, which means proportionally. First, they'll look at the amount in your traditional IRA. Because it's possible to have multiple traditional IRA accounts, they look at the sum of all your accounts, and not just the one you may be using to convert. Next, they examine how much of this amount is pre-tax versus after-tax contributions. Whatever percentage of your account(s) that's pre-tax is the same percentage of money converted to a Roth IRA that you'll owe taxes on.
For instance, if 80% of the money in your traditional IRA is pre-tax, 80% of the money converted to a Roth IRA will be taxable -- and there's no way to only convert after-tax money. If you converted $100,000, you'd owe income taxes on $80,000.
Who should take advantage of backdoor Roth IRAs
Backdoor Roth IRAs generally only make sense for individuals earning over the income limit. If you're below the income threshold, you can save yourself the effort (and tax implications) of IRA conversions by simply contributing directly to a Roth IRA. If you're above the income threshold, the process of creating a backdoor Roth IRA may be well worth the effort -- especially because Roth IRAs don't have required minimum distributions, and accounts can grow tax-free for as long as they're open.