What Is a Backdoor Roth IRA?

Quick Answer

Roth IRAs have income limits that can exclude high earners. A backdoor Roth IRA is a loophole that allows people who make more than the income limit to indirectly contribute to a Roth IRA.

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Individual retirement accounts (IRAs) come with many perks—including some unique tax benefits. Traditional IRA contributions can help reduce your taxable income today, though the withdrawals you make in retirement will be taxed as ordinary income. A Roth IRA is different. While you won't get the tax break now, your distributions are always tax-free (as long as you've held the account for at least five years). It's a nice advantage that could significantly curb your tax burden in retirement.

Here's the catch: Roth IRAs have income limits. If your earnings are too high, you can't contribute to one. A backdoor Roth IRA is a loophole that allows people who make more than the income limit to indirectly contribute to a Roth IRA. Here's how it works.

How a Backdoor Roth IRA Works

A common misconception is that a backdoor Roth IRA—also known as a Roth IRA conversion—is a special type of retirement account. It's actually a strategy that lets high-net-worth investors contribute to a Roth IRA even though their earnings exceed the income limit. Before we get into the nuts and bolts, it's important to first understand the basic structure of a traditional IRA.

Contributions to traditional IRAs are made on a pretax basis. That means they're deducted from the taxable income you report on your federal income tax return in the year they're made. This effectively reduces your tax liability during your working years, when your tax rate might be higher than it will be in retirement. You aren't avoiding taxes, but deferring them. While there are no income requirements to contribute to a traditional IRA, Roth IRAs are a different story.

A backdoor Roth IRA allows you to roll money from a traditional IRA into a Roth IRA. You'll pay taxes on the amount you convert, but will then have a pool of tax-free money waiting for you in retirement—regardless of your income. You're essentially choosing to deal with the tax bill sooner rather than later, but there are some benefits that could make a tax hit now worth your while.

Benefits of a Backdoor Roth IRA

You May Reduce How Much You Ultimately Pay in Taxes

If you withdraw funds from a traditional IRA prior to age 59½, you'll likely be hit with a 10% penalty—not so with Roth IRAs (as long as you've held the Roth for five years and you're withdrawing contributions and not earnings).

Beyond that, if you anticipate your tax rate will be higher in retirement than it is today, contributing to a Roth IRA through the backdoor could reduce your lifetime tax liability.

You Can Avoid Required Minimum Distributions (RMDs)

With tax-deferred accounts like 401(k)s and traditional IRAs, you're required to begin taking minimum distributions when you turn 72. Consider it the federal government's way of nudging you to pay taxes on these funds. Roth IRAs, on the other hand, are not subject to RMDs—even if contributions are made through a backdoor Roth IRA conversion—because you've already paid taxes on the contributions. If you want to continue growing your money by keeping it invested, you're free to do so.

Roth IRA Contribution Limits

There are limits on how much you can contribute to a Roth IRA. Converting the full balance of your traditional IRA may not be possible—and you might not want to. Again, backdoor Roth IRA contributions are considered taxable income. Kicking in too much could inadvertently push you into a higher tax bracket and trigger a hefty bill when you file your next tax return. In terms of how much you can contribute, the IRS will allow you to put in up to $6,000 across all your IRAs (Roth and traditional combined). Folks who are 50 and older can contribute an additional $1,000.

As previously mentioned, Roth IRAs also have income limits. The IRS will begin phasing out your contributions as your adjusted gross income exceeds a certain threshold. Married couples filing jointly must earn less than $204,000 to contribute the maximum amount. Those who are single or married filing separately must earn less than $129,000. But remember, income limits are a nonissue if you contribute through a backdoor Roth IRA.

How to Set Up a Backdoor Roth IRA

Setting up a backdoor Roth IRA is a fairly straightforward process:

  1. Fund an existing traditional IRA. If you don't have one, you can open a new traditional IRA through a bank, investment brokerage, credit union or mutual fund provider. Since you'll likely be leaving some of the balance invested, be sure to choose a provider that gels with your investment style.
  2. Initiate a backdoor Roth IRA conversion. This generally involves reaching out to your IRA administrator to get things going. You'll also need to open a Roth IRA if you don't already have one. The conversion itself can be handled in a couple different ways. You might receive the traditional IRA distribution and then deposit it into your Roth IRA yourself. You'll have a 60-day window to do this. Alternatively, your IRA provider might transfer the funds for you.
  3. Fulfill your tax obligation. Again, you'll be taxed on the amount you convert from your traditional IRA. Knowing what to expect can help you prepare your finances ahead of tax season. If the tax burden will disrupt your financial health, a backdoor Roth IRA may not be worth it.

The Bottom Line

If you'd like to enjoy the benefits of a Roth IRA but earn too much to contribute, a backdoor Roth IRA could make a lot of sense. Just be sure you can easily absorb the tax liability today; otherwise, it could cause unnecessary financial stress. Keeping up with your credit health is another important part of financial wellness. Whether you're at the peak of your career or sliding into retirement, free credit monitoring with Experian can help make things a little easier here.

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