Are you looking for a way to grow your retirement savings? Roth IRAs are a great way to grow your money tax-free. However, once you reach a certain income level, you are likely no longer eligible to contribute to a Roth IRA. Luckily, you might be able to take advantage of a tax loophole that came about in 2010 called a Backdoor Roth IRA. While Roth IRAs have income limits for contributions, a Backdoor Roth IRA allows high-income earners to take advantage of the benefits of a Roth IRA.
What is a Backdoor Roth IRA?
A backdoor Roth IRA is a way to accumulate money in a Roth even if you’re no longer eligible to contribute to a Roth IRA. First, you start off by contributing money to a traditional IRA. This contribution is made with after-tax dollars so you don’t receive a tax deduction for it. Then you do a backdoor Roth conversion to a Roth IRA. You pay taxes on the earnings (not the contributions). Then your investments can grow tax-free and you can make tax-free withdrawals later. It’s completely legal and very simple!
2024 Roth IRA Contribution Limits
|If your filing status is...||And your modified AGI is...||Then you can contribute...|
|married filing jointly or qualifying widow(er)||< $230,000||up to the limit|
|married filing jointly or qualifying widow(er)||> $230,000 but < $240,000||a reduced amount|
|married filing jointly or qualifying widow(er)||> $240,000||zero|
|married filing separately and you lived with your spouse at any time during the year||< $10,000||a reduced amount|
|married filing separately and you lived with your spouse at any time during the year||> $10,000||zero|
|single, head of household, or married filing separately and you did not live with your spouse at any time during the year||< $146,000||up to the limit|
|single, head of household, or married filing separately and you did not live with your spouse at any time during the year||> $146,000 but < $161,000||a reduced amount|
|single, head of household, or married filing separately and you did not live with your spouse at any time during the year||> $161,000||zero|
If your income is above the limit, then you cannot make a Roth IRA contribution. However, you can still make a contribution to a traditional IRA, and then convert it to a Roth IRA using the backdoor Roth IRA strategy.
Wondering if you can make a Backdoor Roth IRA contribution? Find out here!
How does a Backdoor Roth IRA work?
Below are the three steps to do a backdoor Roth IRA strategy.
Step One: Contribute to a Traditional IRA.
This is pretty straightforward. You can do this through any brokerage firm (Vanguard, Fidelity, etc) as this choice is of no significant impact. You have the option of making the maximum contribution for that year ($7,000 in 2024; $8,000 if you’re age 50 or older).
It is crucial to remember that you likely do not want to deduct this contribution from your tax return. If you’re no longer eligible for a Roth, you most likely are also not eligible for a traditional IRA deduction. This is the primary reason people call it a non-deductible traditional IRA.
Step Two: Move your pre-tax IRAs to your current employer plan.
Many people willingly neglect this step, which can lead to a huge tax bill. If you have a rollover IRA that came from an old employer plan (401(k), SEP IRA, etc), it is time to move these to your current employer retirement plan. You may be wondering what that has to do with a backdoor Roth IRA. It has to do with the IRS aggregation rule.
Example: Let’s say you have $95,000 in a rollover IRA. Congratulations on saving that much from your previous job! Now let’s assume you just contributed $5,000 into your new non-deductible traditional IRA. You now have a total of $100,000 in traditional IRA money, 5% of which represents your non-deductible IRA, and 95% of which represents previously tax-deducted contributions. Now, if you do a Roth conversion of that $5,000 (you convert this money from traditional to Roth), the IRS will treat it as if you just converted part of your rollover IRA. So, in this example, you just converted 5% of your total IRA money, most of which was tax-deductible when you contributed, so when you convert to Roth, the IRS wants their cut. This could generate an unnecessary tax bill, which we obviously don’t want.
So, consider moving your pre-tax IRAs into your current 401(k) (or another current employer plan). Every employer plan handles this process slightly differently, so you could start by calling your current employer plan company to get the necessary paperwork to start the rollover process.
Step three: Convert your traditional IRA to a Roth IRA
We recommend you consider doing this step several months after you contribute to your IRA. The reason for this is that the U.S. Tax Court follows a rule called the Step-Transaction Doctrine, which sounds really boring. Essentially this doctrine says that if you do all of these steps consecutively (contribute to a Traditional IRA, and then convert it to a Roth the next day), they will see it as one single transaction. In this case, that would mean you are contributing to a Roth IRA when you are no longer allowed to, and they will slap a penalty on this transaction. You don’t want to risk that! This 12-month rule is not a hard and fast rule. Some advisors think that waiting one month is sufficient, so this is really up to you.
Doing the Roth conversion can be really simple. In Vanguard, for example, there is a button that says “convert to Roth IRA.” So, you just click on that and follow the instructions. In Fidelity, you have to do some searching. Every brokerage firm will handle it slightly differently, but it should not be an overly difficult process.
Now, when asked about tax withholding, you can choose to not withhold taxes so you have more money going into your Roth IRA when you convert. Once you complete the conversion process, you now have a Roth IRA! You can simply repeat these three steps each year to continue growing tax-free retirement money.
Ready to maximize your finances? Schedule your free discovery call today with one of our fee-only financial planners.
Is Backdoor Roth legal?
Yes, the backdoor Roth IRA strategy has been legal since 2010. It is a legal and legitimate way to contribute to a Roth IRA when your income is too high to make direct contributions.
Who is eligible for a Backdoor Roth IRA?
To be eligible for a Backdoor Roth IRA, you must first be eligible to make a Traditional IRA contribution. There are no income limits for contributing to a Traditional IRA.
Once you contribute to your traditional IRA, you can convert these funds to a Roth IRA using the Backdoor Roth IRA strategy. Therefore anyone who is eligible to make a traditional IRA contribution is eligible to do a backdoor Roth IRA. It is not necessary to do a backdoor Roth IRA if you are still eligible to contribute to a Roth IRA.
Can I do a Backdoor Roth every year?
Yes, you can do a Backdoor Roth IRA contribution and a Backdoor Roth conversion every year. The contribution limit for 2024 is $7,000 ($8,000 if you’re age 50 or older). This is the entire amount that you can put into all of your IRAs combined. However, in September 2021, the House Democrats proposed several changes to retirement plans. One of these proposed changes is prohibiting the conversion of an after-tax IRA to a Roth IRA. This would eliminate the backdoor Roth IRA strategy. The Senate has not passed an equivalent bill.
When should I contribute to a Backdoor Roth?
It’s typically best to do the contribution and backdoor Roth conversion in the same calendar year. Basically, you can contribute to a Traditional IRA early in the year, invest that money, then do the backdoor Roth conversion towards the end of the year.
Is Backdoor Roth still allowed in 2024?
Yes, backdoor Roth IRAs are still allowed in 2024.
Who should consider a Backdoor Roth?
A Backdoor Roth may be a good option for people who have maxed out their traditional IRA contributions or who are not eligible to contribute directly to a Roth IRA.
Some situations where a Backdoor Roth IRA may be a good option include:
- High-income earners: If you earn too much to qualify for a Roth IRA, then you can use the Backdoor Roth IRA strategy to contribute to a Roth IRA.
- Maxed-out traditional IRA contributions: If you have maxed out your contributions to a traditional IRA but want to save more, then a Backdoor Roth IRA can allow for additional tax-free growth.
- Retirement savers who are in a lower tax bracket now: If you think that you will be in a higher tax bracket during retirement, then a Backdoor Roth IRA can be used to pay taxes on your contributions now.
A Backdoor Roth IRA is not for everyone and there are some potential tax implications that should be considered. In order to determine if this is the right strategy for you and your financial goals, you should speak with your financial advisor.
Who might not benefit from a Backdoor Roth?
If you’re fully eligible to contribute to a Roth, then you don’t have to do a backdoor Roth. If you have a high-interest consumer loan, you may want to pay that off first before doing a backdoor Roth. If you have a lot of cash but need it for a house down payment in the next year or two, then you may not want to tie that up in a backdoor Roth.
Is a Backdoor Roth the same as a Roth conversion?
The backdoor Roth is the name of the strategy. Roth conversion is the third step in executing the backdoor Roth strategy.
What is the pro-rata rule for Roth conversion?
The pro-rata rule is a rule that applies when you convert funds from a traditional IRA to a Roth IRA, including when using the Backdoor Roth IRA strategy. The rule determines how much of the conversion is subject to income tax. If you have multiple traditional IRAs, including a SEP IRA or a SIMPLE IRA, then you cannot choose which IRA to convert to a Roth IRA. You must include all traditional IRA balances, regardless of which account you are converting from.
The pro rata rule means that if you have both a non-deductible and a pre-tax IRA, then doing a Roth conversion will result in a tax bill. That’s because the IRS will treat a percentage of your conversion as coming from your pre-tax IRA.
The pro-rata bill can complicate the Backdoor Roth IRA. It’’s important to consult with a financial advisor to ensure you comply with the pro-rata rule.
How much money can you convert from a traditional IRA to a Roth IRA?
There is no limit on how much money you can convert from a Traditional IRA to a Roth IRA. You just have to pay attention to the potential tax implications of this conversion.
Can I have 2 Roth accounts?
You can have 2 Roth accounts at the same or different institution. However, your total IRA contribution across all your IRA accounts must still be $7,000 for 2024 ($8,000 for ages 50 and older).
How to fix Backdoor Roth IRA mistakes
Mistake #1: Contributing directly to a Roth IRA when you’re not eligible. To fix this, you can either fill out an excess contribution form or recharacterize your Roth IRA contribution to a Traditional IRA.
Mistake #2: Forgetting to invest your Traditional IRA contribution. This is a common mistake. If you contribute to a Traditional IRA then do an immediate backdoor Roth conversion, it might be seen as a red flag by the IRS. If your contribution has been sitting in a money market fund, you can consider investing it in a diversified fund before doing the backdoor Roth conversion.
Mistake #3: Forgetting to do the Roth conversion. This is an easy one to fix. You can just go ahead and do the Roth conversion. The downside of having waited so long to convert is you will likely owe more taxes upon the Roth conversion if your Traditional IRA investments have gone up. Remember, you have to pay taxes on the earnings (not the contributions).
Mistake #4: Forgetting to move your pre-tax IRAs. This can be a costly mistake. If you convert your non-deductible Traditional IRA while you have a pre-tax IRA (e.g. SEP or Rollover IRA), then it will trigger the IRS pro-rata rule. You will end up with a higher tax bill since the IRS will view it as you have converted part of the pre-tax IRA to a Roth. Fixing this mistake is difficult.
What are the pros of a Backdoor Roth?
- Tax-free withdrawals: It can allow you to grow your money tax-free, even if you are a high-income earner.
- Tax-free growth: You pay your taxes upfront on your converted pre tax funds and then everything after that is tax-free. This benefit is greatest if you think that your tax rates will rise in the future.
- Roth IRAs don’t have Required Minimum Distributions(RMDs). You are not required to take minimum distributions once you reach age 72 with a Roth IRA. This is unlike traditional IRAs where the IRS mandates annual distributions. This means that the account can grow tax-deferred for as long as the account holder is alive.
- No income limits: There are no income limits for converting a traditional IRA to a Roth IRA through the backdoor method. This means that high-income earners can take advantage of this strategy.
- Flexibility: Roth IRA contributions are made with after-tax dollars which means that you can withdraw your contributions at any time without any penalties. We recommend that you leave your contributions to grow tax-free but this option is there in the case of an emergency
Is there any downside to a Backdoor Roth IRA?
The major downside to a backdoor Roth IRA is that executing it properly involves a series of steps. If you make one mistake, you might end up with a higher tax bill. Also, there is always the possibility that tax laws could change in the future which could mean that the Backdoor Roth IRA could be eliminated.
Backdoor Roth IRA tax implications
When you convert your Traditional IRA to a Roth, you will owe ordinary income taxes on the earnings. Say you contributed $7,000 to a Traditional IRA, and after investing the money it grew to $7,600 by the time you did a backdoor Roth conversion. You will owe federal and possibly state taxes on the $600 of earnings.
How do I avoid taxes on a Roth IRA conversion?
You may be able to avoid taxes if you do your backdoor Roth conversion while the stock market is down. If you do the backdoor Roth IRA conversion when the value of your investments in your Traditional IRA is below the contribution amount, then the conversion generates a taxable loss. This can lower your taxable income.
Do you pay taxes twice on a backdoor Roth IRA?
If you have earnings in your Traditional IRA when you do the backdoor Roth conversion, then you have to pay taxes on the earnings. When you withdraw money in your backdoor Roth IRA after 59.5 years old and after the five-year holding period, then no taxes are due.
Does the 5 year rule apply to Roth conversions?
The 5-year rule applies to Roth conversions. This means that you have to wait for 5 years before you can withdraw earnings tax-free from your backdoor Roth IRA. Note that you also have to be at least 59.5 years old.
Do you pay a 10% penalty on Roth conversions?
If you withdraw from your backdoor Roth before age 59.5 years old and before the 5-year holding period, then you typically pay a 10% penalty. You may be exempt from this 10% penalty if the withdrawal is for a first-time home purchase, college expenses, and birth or adoption expenses.
Is a Backdoor Roth a good idea?
If you want to save tens of thousands of tax dollars, then it may be worth your time to learn how to do a backdoor Roth properly. If you save $6,500 a year for 30 years through a backdoor Roth and grow your money by an average of 6% per year, you can potentially generate over $300,000 in tax-free money! It can also be a great idea if you earn too much to contribute to a Roth IRA.
Do you pay taxes twice on a Backdoor Roth IRA?
No, you do not pay taxes twice on a backdoor Roth IRA. The Traditional IRA contributions are tax-deferred until withdrawals are taken. You pay taxes on your contributions and capital gains when you convert your IRA to a Roth IRA. Therefore, when you withdraw your money from your Roth IRA, there are no taxes that need to be paid.
What is the backdoor Roth IRA 2024 deadline?
The deadline for contributing using the backdoor Roth IRA strategy in 2024 is December 31. The contributions must always be made by December 31 of the tax year in which the conversion happens.
What is a mega backdoor Roth?
A mega backdoor Roth is a retirement savings strategy that could allow you to put up to $46,000 in a Roth 401(k) in 2024, on top of your regular $23,000 annual contribution. It is basically the supersized version of the backdoor Roth IRA. The mega backdoor Roth strategy will also be eliminated if the bill proposed by the House is passed by the Senate. Creating a mega backdoor Roth is complicated. It is best to consult a certified financial planner if you want to do a mega backdoor Roth for 2024.
Can you do backdoor Roth and mega backdoor Roth?
Yes, you can do a backdoor Roth and a mega backdoor Roth at the same time. To do a mega backdoor Roth, you need to have access to a 401(k) that allows after-tax contributions, and an in-plan Roth conversion option.
Bonus backdoor Roth IRA tip:
You might be tempted to brag about creating a Backdoor Roth IRA with your CPA or your parents or your friends. You might not want to mention the word Backdoor Roth IRA in your email or text messages. This is again because of that Step-transaction Doctrine we discussed earlier.
Implement a Backdoor Roth IRA strategy today!
A Backdoor Roth IRA can be a valuable tool for high earners who want to take advantage of the benefits of a Roth IRA. However, consulting with a financial advisor is important to determine if a Backdoor Roth IRA is right for you. If you are interested in exploring the Backdoor Roth IRA strategy more and are also interested in a comprehensive financial plan, we’ll be happy to help you. You can schedule a free discovery call with any financial advisor on our team.
Alvin Carlos, CFP®, CFA is an investment advisor and fee-only financial planner, in Washington, D.C that works with clients across the country. He has a Master’s degree in International Relations from SAIS-Johns Hopkins. Alvin is a partner of District Capital, a financial planning firm designed to help professionals in their 30s and 40s achieve their financial goals through smart investing, reducing taxes, retirement planning, and maximizing their money. Schedule a free discovery call to learn how we can help elevate your finances.