What are Backdoor Roth IRAs?

A Roth IRA is a tax-advantaged savings tool that enables people to save and invest after-tax dollars in a retirement account. They can be attractive because savers enjoy tax-free withdrawals during retirement. However, unlike traditional IRAs, Roth IRAs have income limits. All hope isn’t lost for high earners who want to use this retirement savings vehicle thanks to backdoor Roth IRAs. They make it possible for anyone at any income level to take advantage of.

What is a Backdoor IRA?

A backdoor Roth is a strategy investors use to grow tax-free savings in a Roth IRA when they exceed the income limits. The income limits refer to the maximum amount you can earn to contribute to a Roth IRA and that limit changes periodically. You can check the IRS website to find out what the limits are for the current year.

How Does a Backdoor Roth Work?

To carry out a backdoor Roth, you first need to put dollars into a traditional IRA. Once you’ve funded your traditional IRA, you can ask your plan administrator to provide instructions and paperwork for rolling funds into a Roth IRA. If you don’t already have one, you’ll need to open a Roth account.

If your traditional IRA and Roth IRA are with different providers, the two providers may wire the money between one another. In some cases, the traditional IRA provider may give you a check to deposit into your Roth account. If you end up having to do the latter, ensure you do it within 60 days or the IRS may count it as an early withdrawal and charge you taxes and penalties.

The dollars you contribute to a Roth account must be nondeductible, meaning you can’t deduct them from your taxes. You also need to file form 8606 every year you do a backdoor Roth to track your non-deductible contributions.

Additionally, because of the five-year rule, each set of funds you put into a Roth are inaccessible until they’ve been there for at least five years. This rule only applies to those under the age of 59 and ½.

The good thing about backdoor Roths is that there are no income limits, so anyone can do them. A major thing to consider, however, is the tax implications.

Taxes And Backdoor Roths

Tax-deductible contributions are dollars in your traditional IRA that you deducted from your tax return. If you got a tax deduction on any of the funds in your traditional IRA, doing a backdoor Roth could mean you end up paying back those taxes at your marginal income rate. That’s why backdoor Roth contributions are done with non-deductible IRA contributions.

The Pro Rata Rule

Things can get complicated if you have a mix of deductible and non-deductible dollars in your traditional IRAs. This is because once money goes into an IRA you it can be difficult to separate deductible and nondeductible contributions. Unfortunately, the IRS doesn’t allow you to cherry pick and only convert nondeductible dollars into a Roth.

The pro-rata rule helps determine the ratio that will be used to figure out how much of your dollars are taxable when your traditional IRA has both pre-tax and post-tax dollars inside. This formula considers the value of all your IRA accounts, not just the one you made the contribution to. That’s because the IRS aggregation rule makes it so that multiple IRAs count as one.

The formula used for the pro rate rule looks like this:

(non-deductible amount) / (total of all non-Roth IRA balances) = non-taxable percentage

(amount to be converted to Roth IRA) x (non-taxable percentage) = amount of after-tax funds converted to Roth IRA

Note that the pro-rata rule is calculated as of December 31st so one may not know how much of the conversion is taxable until then.

Because of the pro-rata rule, it is often best to avoid commingling deductible and non-deductible contributions in your IRAs, or at least keep them in separate accounts.

Employer-Sponsored Plan Workaround

Those with deductible and non-deductible contributions in their IRAs may be able to still do a backdoor Roth without triggering the pro-rata rule. The trick is to roll their deductible contributions into an employer-sponsored plan, if possible. By doing this, you are left with only non-deductible contributions.

Once your non-deductible contributions are isolated you can perform the Roth conversion without having to account for the pro-rata rule.

The Bottom Line

Backdoor Roth IRAs allow high-earners to save more post-tax income, which can be withdrawn tax-free after age 59 and ½. Roth IRAs also aren’t subject to RMDs. The foundation of efficient tax planning is paying taxes when tax rates and income are low, and using tax-free income when tax rates and income are high. Backdoor Roth contributions are a powerful tool for retirement and tax planning. Before moving ahead, it’s advisable to seek advice from a tax professional or financial advisor so you know what the tax implications will be and can plan towards it.