- The backdoor Roth IRA converts nondeductible traditional IRA contributions to a Roth account, avoiding the usual Roth income limits.
- It’s not a tax dodge: Income taxes are still paid on the money before it’s converted.
- If you already have a number of IRAs, though, a backdoor IRA may not be the best option due to the IRA aggregation rule.
IRAs, or Individual Retirement Accounts, are some of the best ways to save for retirement. Although IRAs come in many different flavors, the two most common are traditional IRAs, in which contributions are deductible when they’re made, but taxable later on during withdrawal, and Roth IRAs, in which money is taxed before you contribute but tax-free when you make withdrawals.
It’s easy to see why Roth accounts are attractive: Tax-free retirement income is a great starting place, along with the lack of RMDs (required minimum distributions) that obligate you to begin taking withdrawals once you reach a certain age designated by the IRS. These features also make Roths an excellent way to pass on an inheritance.
But not everyone can contribute to a Roth IRA. There are income limits. So if you make too much money, you’re locked out of the benefits of a Roth IRA.
Or are you?
How does the Backdoor Roth IRA work?
A backdoor Roth is a financial strategy in which nondeductible contributions are made to a traditional IRA, and then immediately converted to a Roth. In this way, people whose income exceeds the normal Roth contribution income limits—$144,000 for single filers or $214,000 for married people filing jointly in 2022—can still take advantage of Roth benefits.
Because the contributions are nondeductible, the money contributed and converted will still count toward that year’s taxable income. And as always, you can only contribute up to the annual limit to any and all IRAs you might hold, traditional and Roth combined. The limit in 2022 is $6,000, or $7,000 if you’re 50 or over.
For the time being, it’s a perfectly legal loophole that allows higher income earners to bypass the income limit for contributing to a Roth IRA outright. But lawmakers have their eye on the backdoor Roth and legislation may soon pass making this strategy impossible.
Backdoor Roth IRA vs. a Roth conversion
People often use the terms backdoor Roth and Roth 401(k) interchangeably, says Malik S. Lee, a Certified Financial Planner and founder of Felton & Peel Wealth Management. Either way, “technically speaking, you are converting traditional IRA money to Roth funds,” he says.
However, while a backdoor Roth involves a Roth conversion, they’re not one and the same.
While the backdoor Roth IRA is one very specific tactic for circumventing the Roth income limits, it’s also possible to simply convert existing, pre-tax IRA funds from traditional to Roth status. You can convert any amount in a given year, making it possible to instantly create a large Roth IRA balance—but because the funds in the traditional account are pre-tax, you’ll be liable for the income taxes the year you make the conversion.
Should you consider a backdoor Roth IRA?
While creating a backdoor Roth IRA can be a good retirement game plan for some, it’s not right for everyone.
Case in point, Lee advises his high-income-earning clients to consider the backdoor Roth strategy only “when they have exhausted all pre-tax vehicles first.”
That’s because for earners in higher tax brackets, the tax break today might be more valuable than the tax-free income later down the line—especially if they believe they will be in a lower income bracket at retirement. For example, if you’re at the 32% bracket today and put funds into a Roth, you’ll pay a lot more income tax than you would if you put them into a traditional account and took them out at a 12% bracket later.
There’s also another scenario where a backdoor Roth IRA isn’t a great idea: “I avoid this strategy when a client has considerable existing rollover IRA or deductible traditional IRA accounts,” says Lee. “That’s because it will be subject to the IRA aggregation rule, which can make the contribution taxable.”
Keep in mind, the IRA aggregation rule combines all the IRAs you may hold (except Roths) into one body of funds for tax purposes. So even if you have some pre-tax money in an IRA, you won’t gain any tax benefits by putting that money in a Roth IRA because you will have to pay taxes on all your combined IRA contributions, whether they are pre-tax or not.
Depending on your current retirement holdings, that means implementing a backdoor Roth could lead to a considerable tax bill, which may or may not be worth the strategy’s benefits.
As always, there’s no “one-size-fits-all” answer to any financial strategy, the backdoor Roth IRA included. If you have specific questions, it might be worthwhile to talk to a qualified financial professional.