A backdoor Roth IRA is a way for those who earn too much to contribute to a Roth IRA to still take advantage of one. The backdoor Roth is a technique, not an official account type.
What Is a Backdoor Roth IRA?
A backdoor Roth IRA is a technique by which investors whose income is too high to make a direct Roth IRA contribution can divert funds to a Roth IRA account.
For 2019, the income limits to be able to contribute to a Roth IRA are:
- If your modified adjusted gross income (MAGI) is less than $122,000 you can contribute the full amount.
- If your MAGI is in the range of $122,000 to $136,999 than you can contribute a phased-out amount based on where your income falls within this range.
- No contributions can be made if you MAGI is $137,000 or more.
Married Filing Jointly
- If your MAGI is less than $193,000 you can contribute the full amount.
- If your MAGI is in the range of $193,000 to $202,999 than you can contribute a phased-out amount based on where your income falls within this range.
- No contributions can be made if you MAGI is $203,000 or more.
How Does a Backdoor Roth IRA Work?
A backdoor Roth IRA is a workaround for those who earn too much to contribute to a Roth IRA account directly.
A backdoor Roth IRA involves contributing to a traditional IRA account then converting that contribution to a Roth IRA. There are no income limitations on after-tax contributions to a traditional IRA account, there are for pre-tax contributions to a traditional IRA if you are covered by a retirement plan, such as a 401(k), by your employer.
Benefits of a Backdoor Roth IRA
Roth IRA accounts are not subject to taxes upon withdrawal as long as your first Roth was opened at least five years prior and you are at least age 59½. Tax-free withdrawals in retirement can be appealing.
Some benefits of a Roth IRA account and reasons to consider a backdoor Roth IRA include:
- A Roth IRA account can provide tax diversification for your retirement savings if you also have retirement money in a traditional IRA and other pre-tax retirement accounts such as a 401(k).
- Roth IRAs are not subject to required minimum distributions at age 70½ like traditional IRAs. If you don't need to withdraw the funds they can stay invested until needed. This feature makes a Roth IRA an excellent estate planning vehicle as these funds can be passed to a spousal beneficiary and retain their tax-free status. Non-spousal beneficiaries will have to take required minimum distributions, but these distributions will not be taxed.
How Do You Open a Backdoor Roth IRA?
There are a number of steps involved in creating a backdoor Roth IRA:
- Fund a traditional IRA account with an after-tax contribution. For tax year 2019, the maximum contribution allowed to an IRA is $6,000 with an extra $1,000 catch-up contribution for those who will be 50 or older at any point during the year. If you don't have a traditional IRA account already open, you may need to open a new IRA account.
- If you don't have one, be sure to open a Roth IRA account.
- If you haven't done a backdoor Roth in the past, it is a good idea to discuss the process with the custodian of the accounts.
- You then convert the money contributed to the traditional IRA account to a Roth. This could be just the contribution for the current tax year or could include additional funds in the traditional IRA.
It should be noted for those with access to a 401(k) plan through their employer, if the plan offers a Roth option, there are no income limits. You can contribute up to the maximum levels to the Roth option, though any employer matching will be made to a traditional account option.
What are the Tax Implications of a Backdoor Roth?
The tax implications of doing a backdoor Roth will vary based on your situation.
- Money that was contributed on a pre-tax basis will be taxed in the year the Roth conversion is done.
- Any earnings within the traditional IRA account, regardless of whether the contribution was made on a pre-tax or an after-tax basis, will be taxed in the year converted.
- Taxes due on the conversion to the Roth are ordinary income taxes, not capital gains taxes.
If the contribution to the traditional IRA is made on an after-tax basis, if there are no earnings on that contribution within the account and if you have no other funds in a traditional IRA account then the entire amount can be converted tax-free.
If you are looking to convert after-tax contributions, but also have money in traditional IRA accounts that were contributed on a pre-tax basis and/or is the result of tax-deferred gains in the account, then the conversion of the after-tax contribution will be partially taxed. The percentage of the conversion that will be taxed will be the same as the percentage of the traditional IRA funds that don't consist of after-tax money.
For example, your traditional IRA account has $100,000 that was all contributed on a pre-tax basis. You contribute $6,000 on an after-tax basis and immediately convert that amount to a Roth IRA. The amount taxed would be $5,660 or roughly 94.3% of the total ($100,000 divided by $106,000).
One tactic to avoid being taxed if you have funds in a traditional IRA account that would put you in this situation is to do a reverse rollover of these IRA funds to your 401(k) plan at work if your employer allows this. For those who are self-employed, you could do this same thing into a solo 401(k) account.
This would then allow you to make after-tax contributions to a traditional IRA and convert those contributions tax-free each year to a Roth IRA.