What Is a Backdoor Roth IRA?
A backdoor Roth IRA is a loophole in the tax system that allows high-income earners who normally can’t invest into a Roth IRA to do so by creating a “backdoor” Roth. In a backdoor Roth IRA, you take funds from a traditional IRA (which has no income limits for contributions) and convert them into a Roth IRA.
Sounds simple right?
Well, we’re dealing with the IRS, where nothing’s simple. The IRS headache is one of the reasons we recommend setting a goal for your future retirement as part of our FIRE ladder, so that you can strategize your investing accordingly to minimize your tax burden in retirement.
Who Might Consider a Backdoor Roth IRA?
The IRS limits the total amount of income you can make if you want to invest in a Roth IRA. For 2023, the cap is a modified AGI of $228,000 for married filing jointly, with a reduced amount of the $6,500 contribution limit allowed for MAGIs between $218,000 and $228,000. For single or head of household filers, the cap is $140,000 with a phase out range of $125,000 – $140,000. If your MAGI is within this reduction amount, you can learn more about calculating the reduced contribution limit here (for 2023).
Note: the modified AGI is not the same as the gross income you earn in a year. “For most taxpayers, MAGI is adjusted gross income (AGI) as figured on their federal income tax return before subtracting any deduction for student loan interest.” (1)
For those who don’t know what AGI is, well… it’s complicated. “Adjusted Gross Income (AGI) is defined as gross income minus adjustments to income. Gross income includes your wages, dividends, capital gains, business income, retirement distributions as well as other income. Adjustments to Income include such items as Educator expenses, Student loan interest, Alimony payments or contributions to a retirement account. Your AGI will never be more than your Gross Total Income on you return and in some cases may be lower.” (2)
If your MAGI for the tax year might be close to the phase out range, will be within the phase out range, or will be above the phase out range, you might want to consider a backdoor Roth IRA.
Why Might You Consider a Backdoor Roth IRA?
Converting from a traditional IRA to a Roth IRA lets you pay your taxes up front and lets all the future earnings grow tax-free. If you are early in your working career and have several decades left until retirement, the compounding growth can really add up.
Is a Backdoor Roth IRA a Good Idea for Me?
Ready for everyone’s favorite answer: it depends!
If you are at a couple with a MAGI/AGI of $228,000 in 2023, your income hit the 24% tax bracket, and becomes 32% at $364,200. The higher your income is in the year you do a backdoor Roth, the higher the tax bill you’re going to have.
If your investing into an after-tax IRA and immediately converting to a Roth, then you still have a higher tax burden you already paid on the funds being converted.
There’s something to be said about why the IRS puts limits on Roth contributions – at a certain income limit and as your income hits the higher marginal tax rates, you might be better off paying taxes in retirement where your income is likely to be lower and thus taxed at 12% or 22% with proper asset allocation across your different investment accounts, depending on your goals for lifestyle in retirement.
There are, of course, other factors to consider. For instance, the marginal tax rates might go up before you hit retirement. Leaving it in a traditional IRA means you don’t have to pay taxes now at potentially a higher tax rate, but you will owe taxes on all the growth once you go to withdraw. The younger you’re putting into a Roth and the more time it has to grow, the more enticing the Roth can become.
This is where it might be worth talking to your financial planner or breaking out an earnings growth estimating spreadsheet to make sure you’ve assessed the cost/benefit analysis for your particular situation and retirement goals. Nothing is a guarantee, of course. Situations change, taxes change, not just year to year but certainly over the next few decades before you reach the minimum retirement age to withdrawal without penalties.
No matter which decision you make, it’s a good problem to have because it means you’re killing it with your income! And the fact that you’re looking into the backdoor Roth IRA means you’re paying attention to your retirement and investing strategies. Take a bow, my friend!
How to Set up a Backdoor Roth IRA
If you don’t have one yet, set up a traditional IRA. In order to do a backdoor Roth IRA, you will have to first have to have the funds into a traditional IRA and then transfer them over into a Roth IRA.
This process is the easiest when you have both the Roth IRA and traditional IRA at the same company (which I typically recommend anyway because fees tend to drop the more assets you have with a particular company). It isn’t impossible if you are moving funds from a traditional IRA with one institution to a Roth at another, it’s just a little more complex. In this situation, you want to make sure you set it up properly so you don’t accidentally take it as a withdraw (subject to penalties) instead of a transfer. In this case, it’s best to call up the receiving institution and walk the process through with them to make sure you know their particular process.
Some companies will let you transfer directly from one to another. For example, when my husband left his previous job, we were easily able to transfer his 401(k) to his traditional and Roth IRAs using the companies’ websites. When I left my previous job, however, I wasn’t able to do the transfer through the websites and have the current company send the funds directly to the receiving company. Instead, I had to have my 401(k) management company send checks to me (made out to the receiving company) and mail them to the receiving company. 401(k) to IRA transfers are a little different, but follow the same process.
If you have to do a rollover via check, make sure you pay attention to your window. You have sixty days to get the check sent to and received into your Roth to avoid the IRS deciding you took a withdraw and slapping you with a penalty. Needless to say, this process is the most stressful! Although some institutions allow you to mobile deposit the checks – it all depends on how they’re set up.
Taxes and the IRS Pro-rata Rule
If you are putting post-tax funds into your traditional IRA to do a backdoor Roth IRA and already have other funds in a traditional IRA, then the IRA is going to look at your overall portfolio of your traditional IRAs and pro-rate the amount of taxes you owe on the conversion. (Uncle Sam is gonna get his money, one way or another!)
For example, if you put $6,500 of post-tax dollars into your traditional IRA that has $58,500 in other pre-tax dollars (for a total of $65,000 between the pre-tax and post-tax dollars), even though your intention is to directly move the $6,500 post-tax dollars to the Roth IRA, the IRS sees that $6,500 as part of an overall balance of $65,000 and will charge you a pro-rated tax amount that gets billed on your return. For this situation, you’re post-tax portion is $6,500/$65,000 = 0.1, or 10%. So the taxable portion is the other 90%. For a backdoor Roth IRA conversation of the $6,500 post-tax contribution you intended to transfer, you’d owe taxes at your marginal tax rate for 0.90*6500 = $5,850. It’s not a large amount overall, but it can still hurt if you’re in a higher tax bracket.
If you don’t contribute to a traditional IRA and immediately transfer it to your backdoor Roth IRA, you have to assess the overall growth of the post-tax versus pre-tax mix within your traditional IRA and do the pro-rata percentage based on the growth when determining what your tax bill will be.
One strategy you can do to get around this pro-rata rule, if your employer retirement plan allows, is roll your pre-tax traditional IRA funds into your employer plan. But a lot of times, the funds available in your employer plan are restricted and the fees can be higher (which is why we typically roll 401(k)s to IRAs when leaving an employer). It can become quite the headache for a $6,500 contribution limit.
If you have two different traditional IRAs at two different institutions, the amount of the IRA you put the post-tax amount into doesn’t matter. The IRS looks at the balance across all of your traditional IRA accounts.
When assessing this pro-rata rule, the more pre-tax money you have in your account, the less enticing the backdoor Roth IRA may seem. Again, this is where it’s important to assess your own current situation and goals.
Since paying the taxes out of the amount your transferring to the backdoor Roth IRA eats away at the amount you have in your Roth, and thus limits your tax-free growth, it’s better to pay the taxes out of other take-home income, instead of from the funds you are transferring from the traditional IRA to the Roth.
Contribution Limits
Since a backdoor Roth IRA requires funding a traditional IRA and then transferring the funds to a backdoor Roth IRA, the backdoor Roth IRA carries the same annual contribution limits as a regular Roth IRA.
The exception to this is a mega backdoor Roth IRA, which is a different strategy that skirts around the annual contribution limits by using an employer-sponsored retirement plan that supports such a conversation. (This can get even more complicated, so we’ll cover it at another time if it’s of interest to anyone; let us know in the comments below.)
You want to be cautious of doing a backdoor Roth IRA and a mega backdoor Roth IRA too close in time together, because the IRS has something called a step-transaction doctrine that they can use to combine a series of separate steps into one event, which can land you in an over-limit contribution sticky situation if you aren’t careful.
References:
(1) https://apps.irs.gov/app/IPAR/resources/help/MAGI.html
(2) https://www.irs.gov/e-file-providers/definition-of-adjusted-gross-income