If you earn too much to contribute directly to a Roth IRA, there’s still a way in. A backdoor Roth IRA allows high-income earners to enjoy the tax-free growth of a Roth account using a legal workaround. It takes a few steps, but the long-term benefits can be well worth the effort.
What Is a Backdoor Roth IRA?
A backdoor Roth IRA is not a special account, but rather a strategy. It involves making a nondeductible contribution to a Traditional IRA and then converting that amount to a Roth IRA. The IRS places income limits on who can contribute directly to a Roth IRA. However, there are no income limits for converting funds from a Traditional IRA to a Roth IRA.
This method is popular among people whose income is above the Roth IRA limits but who still want to benefit from tax-free withdrawals in retirement. While it sounds simple, there are rules and timing issues to be aware of before you begin.
Step 1: Make a Nondeductible Contribution to a Traditional IRA
The first step in setting up a backdoor Roth IRA is to open a Traditional IRA if you don’t already have one. Then you make a contribution to it, but you don’t take a tax deduction for that contribution. This keeps the amount taxed only once.
Be sure to document that your contribution is nondeductible by filing IRS Form 8606 with your tax return. This tells the IRS you already paid taxes on the money you’re about to convert. Skipping this step can lead to paying unnecessary taxes later.
Step 2: Convert to a Roth IRA
After the funds are in your Traditional IRA, you convert them to a Roth IRA. Many people choose to do this soon after the contribution, sometimes within days. The idea is to convert before the money has time to grow, which helps avoid taxes on any gains.
Your brokerage firm will guide you through the conversion process. The conversion itself is a taxable event, but since you already paid taxes on the original contribution, only the earnings—if any—will be taxed. If you convert quickly, the tax bill is usually small or zero.
Step 3: Be Aware of the Pro Rata Rule
One important detail many overlook is the pro rata rule. If you have other pre-tax money in Traditional IRAs, SEP IRAs, or SIMPLE IRAs, the IRS considers all of your IRA funds together when calculating how much of your conversion is taxable.
For example, if you have $90,000 in pre-tax IRA money and add a $6,000 nondeductible contribution, then try to convert only the $6,000, the IRS won’t allow it. Instead, they’ll apply the pro rata rule. This means most of your conversion could be taxed. If this applies to you, it’s a good idea to talk with a tax advisor before moving forward.
Why Choose a Backdoor Roth?
The main advantage of a Roth IRA is tax-free growth and withdrawals in retirement. Unlike Traditional IRAs, Roth IRAs don’t have required minimum distributions (RMDs), which means you can leave the money in your account as long as you want. That can help with estate planning or managing your income in retirement.
Backdoor Roths offer a legal way for high earners to access these benefits. While it adds a few extra steps, the long-term gains can outweigh the effort, especially if you’re years away from retirement.
In addition, a Roth IRA gives you more control over your taxes in retirement. You can choose whether to pull money from taxable or tax-free accounts, helping you avoid jumping into a higher tax bracket.
Stay Organized and Plan Ahead
Setting up a backdoor Roth IRA requires good record-keeping. Keep notes on your contributions, dates, and any tax forms filed. Mistakes can lead to unexpected taxes or penalties, so it’s worth doing carefully.
Also, it’s smart to complete the contribution and conversion in the same tax year when possible. This avoids confusion and makes it easier to report to the IRS.
Make the Most of Your Retirement Planning
A backdoor Roth IRA can be a powerful tool for building tax-free income in retirement, especially if your income makes you ineligible for a direct Roth contribution.
While it does require more attention and planning than a standard IRA, many find the long-term benefits to be well worth the effort. With the right steps and some careful timing, you can turn today’s savings into tomorrow’s peace of mind.