What do you do if you get locked out of the front door of your house? Simple: you check the back. You can use the same tactic with Roth individual retirement accounts (IRAs).
The IRS sets income limits for Roth IRA contributions that may disqualify certain participants—in essence, locking the front door. But according to Andrea Osorio, senior wealth advisor at Citi Personal Wealth Management, there’s a legal way to get around these regulations: a simple tactic known as a backdoor Roth IRA.
What is a backdoor Roth IRA?
A backdoor Roth IRA is a legal loophole people who earn above the Roth IRA income limits can use to get more money into a Roth IRA where all future growth is tax-free.
Through this strategy, you can convert traditional IRA dollars into a Roth IRA. The ideal candidate for a backdoor Roth IRA is someone who earns above the Roth IRA income limits, does not already have other pre-tax IRA savings, and won't need the Roth IRA funds for at least five years, says Ginger Ewing, a private wealth advisor at Ameriprise Financial. She adds that the younger you are when you do a backdoor Roth IRA, the better, as this will give your money more time to grow tax-free.
Why would you use a backdoor Roth IRA?
"The goal of a backdoor Roth IRA is to get more dollars into your tax-advantaged retirement vehicle where all future growth is tax-free," says Patrick McDonald, a certified financial planner and managing partner at Manhattan West.
For many taxpayers, one of the biggest attractions to a Roth IRA is that the contributions grow tax-free, meaning that as long as you wait five years and until age 59 ½ to make any withdrawals, there will be no taxes paid on distributions. With a traditional IRA, the contributions lower what you pay in taxes now but when it comes time for a distribution in the future, you’ll pay whatever the current tax rate is at that point in time.
What's more, Roth IRA assets are not subject to required minimum distributions (RMDs) during the original owner's lifetime and can go to heirs tax-free if the account is more than five years old—although the heir will need to begin regular withdrawals upon receipt.
The IRS imposes income limits on who can contribute to a Roth IRA and how much they can put away. In 2023, individual tax filers with an adjusted gross income (AGI) of $138,000 or more ($218,000 or more or married filing jointly) can't make the full Roth IRA contribution. Individual filers with an AGI of $153,000 or more ($228,000 or more for married filing jointly) can't contribute directly to a Roth IRA at all in 2023.
Traditional IRAs are not subject to the same type of income limits. Anyone with earned income can contribute to a traditional IRA, but if you earn above a certain threshold you may not be able to take a tax deduction for your contribution. For example, in 2023 individuals with an AGI of $83,000 or more ($136,000 or more for married filing jointly) cannot deduct any traditional IRA contributions on their tax returns.
Backdoor Roth IRA conversions and taxes
This is where things can get messy for backdoor Roth IRAs. If done correctly, a backdoor Roth IRA is a non-taxable event, but this can be a big "if."
IRS pro rata rule
The reason backdoor Roth IRA taxes get complicated is the IRS's pro rata rule for IRA conversions. Under this rule, if you have both pre-tax and after-tax dollars in a traditional IRA when you do a backdoor Roth IRA, the conversion will be a proportional share of both types.
For example, say your traditional IRA already has a balance of $4,000 when you make a non-deductible contribution of $6,000 for your backdoor Roth IRA. When you do the conversion, the IRS doesn't let you take just the after-tax $6,000. Instead, your conversion will be 40% pre-tax and 60% after-tax, just like your overall IRA. You'll have to pay ordinary income taxes on the pre-tax amount in the year the conversion occurs.
IRA aggregation rule
To make the pro rata rule even more annoying, the IRS views all IRA assets as a single entity. "Even if you have 10 different accounts, as far as the IRS is concerned, it's all looked at as one," Osorio says. Therefore, you can't avoid the pro rata rule simply by opening a new traditional IRA just for non-deductible contributions.
You may experience the same problem if you leave your non-deductible contribution in your traditional IRA too long before converting to a Roth. Any earnings inside your traditional IRA are considered pre-tax dollars subject to the pro rata rule.
If you wait to convert your traditional IRA contributions until a later date, you'll also need to keep track of your non-deductible basis from year to year on IRA Form 8606. "This can be a headache," Ewing says, and something you must keep tracking "until all of your IRAs have a $0 balance," which could take the rest of your life.
To help avoid creating a taxable event, McDonald recommends not investing any of the funds you've earmarked for your Roth IRA. Let it stay in cash until the conversion is complete, and you can invest it once it arrives in your Roth IRA.
Tax software won't help
Unfortunately, tax software like Turbotax probably can't help you here because a backdoor Roth IRA is considered a loophole and is therefore not something the software will recommend using. According to McDonald, "It's an absolute nightmare to get it correct."
Even some CPAs aren't well-versed in the strategy, he adds, so make sure you find someone familiar with it to help you file your taxes.
Pros and cons of backdoor Roth IRAs
Given the tax headache that a backdoor Roth IRA can be, you may be questioning if it's even worth the effort. Perhaps considering the pros and cons of a backdoor Roth IRA will help you decide.
Pros
- Tax-free growth. The key benefit to a Roth IRA and primary reason anyone attempts a backdoor Roth IRA is so their savings can grow tax-free.
- No RMDs. Roth IRAs are also not subject to RMDs (required minimum distributions), which means you can leave the money in there as long as you'd like. Translation: even more tax-free growth.
- Tax-free inheritance. Even your heirs can withdraw money from your Roth IRA tax-free, making this one of the best vehicles for leaving a legacy.
- Access. You can withdraw your backdoor Roth IRA conversion without penalty at any age, provided the money has been in the account for at least five years.
Cons
- Makes your taxes more complicated. Filing your taxes gets much more complicated when you do a backdoor Roth IRA, largely because this strategy is not widely recognized by tax filing software or CPAs.
- IRS pro rata rule. The IRS pro rata rule can cause a backdoor Roth IRA to be a taxable event if you have other pre-tax IRA assets.
- Must wait five years to withdraw after each conversion. The five-year rule applies to each backdoor Roth IRA conversion. "If you do a backdoor Roth IRA conversion every year, you must wait five years to access each portion you convert," McDonald says.
- Timing is key. To minimize the impact of the pro rata rule, you'll want to do the backdoor Roth IRA conversion as soon as possible after you make your non-deductible IRA contribution so the money doesn't have time to generate earnings.
The ideal candidate for a backdoor Roth IRA is a young, high income earner without a lot of other IRAs, Osorio says. "The younger the better" because you have time for compound interest to work in your favor. Not having other IRA accounts keeps tracking your conversion simple while helping you avoid issues with the pro rata rule.
How to complete a backdoor Roth IRA conversion
There are three ways to complete a backdoor Roth IRA conversion depending on how much you want to convert and which account you're converting from.
Partial rollover from a traditional IRA
You don't have to convert your entire traditional IRA to a Roth in one sweep. Instead, you can rollover only a portion of your existing traditional IRA with the following steps.
- Open a traditional IRA. If you don't already have a traditional IRA, start by opening a new account for your non-deductible contribution.
- Make a nondeductible IRA contribution. If you don't already have IRA assets to convert, start by making a non-deductible contribution to your IRA. If you already have assets to convert, skip to step two.
- Convert assets to a Roth IRA. Follow the instructions from the firm where you hold your IRA assets to complete the backdoor Roth IRA conversion for the portion of your traditional IRA you wish to convert.
- Remember the pro rata rule. Don't forget to apply the pro rata rule if you have any pre-tax assets in traditional IRAs at the time of your backdoor Roth conversion.
Full rollover from a traditional IRA
You can also roll over all of the assets inside your traditional IRA to a Roth IRA following many of the same steps as above.
- Open a traditional IRA. If you don't already have a traditional IRA, start by opening a new account for your non-deductible contribution.
- Make a nondeductible IRA contribution. If you don't already have IRA assets to convert, start by making a non-deductible contribution to your IRA. If you already have assets to convert, skip to step two.
- Convert assets to a Roth IRA. Follow the instructions from the firm where you hold your IRA assets to complete the backdoor Roth IRA conversion.
- Remember the pro rata rule. Don't forget to apply the pro rata rule if you have any pre-tax assets in traditional IRAs at the time of your backdoor Roth conversion.
Note that some firms might close your traditional IRA if you take all the money out, Ewing says. This shouldn't be a problem because you can usually open a new account later, but do keep an eye out for applicable closing fees.
Rollover from a 401(k) plan
You can transfer money from your 401(k) plan to a Roth IRA through a 60-day rollover or direct rollover.
- 60-day rollover: your employer issues a distribution from your 401(k) that you then have 60 days to put into your Roth IRA to avoid paying the 10% early withdrawal penalty. Your employer will probably withhold 20% of your distribution, as per IRS rules.
- Direct rollover: your employer lets you transfer money directly from your 401(k) plan to your Roth IRA. Since the money is never issued directly to you, no taxes are withheld.
The pro rata rule will apply in each of these instances, so be prepared for taxes if you have both pre- and after-tax money in your 401(k).
Regardless of which strategy you use, it's best to only do a backdoor Roth IRA conversion under the guidance of a financial advisor and tax professional to help you avoid any penalties and unintended tax consequences because they can quickly get messy.
The takeaway
Backdoor Roth IRAs can be a handy loophole for people who earn too much to contribute directly to a Roth IRA but still want to access the tax-free benefits of these powerful savings vehicles. But since it’s a workaround, this strategy is more complicated than most.
Backdoor Roth IRAs have "been under a microscope for a long time by the IRS," McDonald says. While they haven't disallowed them yet, this could change at any time.
As such, it’s crucial to stay abreast of any new tax laws each year if you’re intrigued by this strategy. "New laws affecting IRAs have been passed, it seems, at least annually lately," Ewing says. The last thing you want to do is get caught doing a backdoor Roth IRA the year the IRS decides to lock this backdoor, too.
Frequently asked questions for backdoor Roth IRAs
Can you still do a backdoor Roth IRA in 2023?
Yes, backdoor Roth IRAs are allowed in 2023. That said, the IRS could change this rule in future years so be sure to check each year you plan to do a backdoor Roth IRA and consult with a tax professional.
Is a backdoor Roth IRA a recharacterization or a conversion?
A backdoor Roth IRA is a conversion where you convert traditional IRA dollars into Roth IRA dollars. A recharacterization is when you change the designation of a regular annual contribution from one IRA type to another.
Is it a good idea to do a backdoor Roth IRA?
A backdoor Roth IRA can be a good idea for high-income earners who are otherwise prohibited from contributing to a Roth IRA. However, this strategy is also complicated and can have unforeseen tax consequences if not done correctly. As such, it's best to only do a backdoor Roth IRA under the guidance of an experienced financial professional.
