Roth IRAs are among the best retirement accounts available because of their unique tax break. Instead of contributions being deductible like a 401(k) or traditional IRA, contributions are made after tax with the chance for tax-free withdrawals in retirement.
Having the opportunity to have your investments grow and compound without taxes waiting at the end is a financial gift. Countless people save thousands of dollars using a Roth IRA.
Unfortunately, not everyone is eligible to contribute to a Roth IRA because of its income limit. In 2024, the most you can earn and contribute to a Roth IRA is $161,000 if you're single and $240,000 if you're married and filing jointly. If you're ineligible for Roth IRA contributions, however, there is another route you can take.
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All signs point to the backdoor
People over the Roth IRA income limit can still get an account through a backdoor Roth IRA. It's not an official retirement account, more so a means to sidestep the income limit. Here's the broad two-step process:
- Contribute to a traditional IRA account: There aren't any income restrictions to contribute to a traditional IRA, so they're accessible to anyone. If you already have a traditional IRA, just contribute to it. If you don't have an account, open one through your desired financial institution and contribute your desired amount.
- Convert your traditional IRA to a Roth IRA: After you've made your contribution to the traditional IRA, contact your IRA provider to start a conversion to a Roth IRA. There aren't any income restrictions for the conversion, either. This process can vary between providers, so consult your plan administrator for specific guidance. If you don't have a Roth IRA already, you will establish one as part of the conversion process.
You can't use this move as a tax escape
The appeal of a traditional IRA is mainly that many people get to deduct their contributions, although that depends on factors like your income, filing status, and whether you or your spouse's employer provides a retirement plan. Conversely, a Roth IRA is exclusively designed for after-tax contributions.
If you get to deduct your contributions made to a traditional IRA and then convert them to a Roth IRA, you will probably have to include the full conversion amount as taxable income. However, the deduction for the traditional IRA contribution and the income from the conversion will cancel each other out.
Additionally, the rules for withdrawing funds from a Roth IRA differ depending on the source of the funds. While you can withdraw contributions (but not earnings) from a Roth IRA at any time without penalties, funds transferred to a Roth IRA via conversion have a different rule. These converted funds must remain in the Roth IRA for at least five years if you are under 59 1/2 years old to avoid withdrawal penalties.
The IRS sometimes uses a pro rata rule for taxing conversions
Consider a scenario where you contribute $6,500 to a traditional IRA (the 2024 maximum for people younger than 50), but you're unable to claim a tax deduction because of your income level. You then convert it to a Roth IRA. In this case, you could owe income taxes on a portion of the $6,500.
If the only IRA assets you had were the nondeductible contribution, then you wouldn't owe tax on the conversion. However, if you had other traditional IRA assets that you did get a tax deduction for earlier, then the IRS will tax a portion of the converted amount. Specifically, the IRS will look at the sum of all your IRA accounts and determine how much of your traditional IRA is pre-tax (meaning you took a deduction) versus after-tax contributions. Whatever percentage of your account(s) is pre-tax money is the pro-rata percentage it will apply to the conversion amount.
For instance, if 70% of the money in all of your traditional IRAs is pre-tax, 70% 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 $10,000, you'd owe income taxes on $7,000.
Who do backdoor Roth IRAs make sense for?
The most obvious choice to use backdoor Roth IRAs are high earners who are ineligible to contribute to a regular Roth IRA. After all, if you're eligible to use a Roth IRA, there's no reason to go the backdoor route. It's just extra work.
For high earners, backdoor Roth IRAs can offer a unique opportunity, but make sure you know the tax implications behind the move. If you have time on your side, the chance of having your money grow and compound with tax-free withdrawals could be well worth it.
