What Is a Backdoor Roth IRA?

What Is a Backdoor Roth IRA? loading="lazy"

A backdoor Roth IRA is a workaround high-income taxpayers can use to contribute to a Roth IRA. The method is allowed by the IRS, but there are some things to keep in mind, particularly the long-term benefits versus the short-term drawbacks.

How Does a Backdoor Roth IRA Work?

The Roth IRA is a tax-advantaged retirement account that functions differently from traditional IRAs, 401(k)s and other employer-sponsored retirement plans.

Unlike with a traditional IRA or 401(k), Roth IRA contributions are made using income that's already been taxed, so they can't be deducted on your tax return. However, the reward for using after-tax income to fund your retirement is that contributions in a Roth IRA grow tax-free. What's more, you can avoid being taxed when you take distributions as well.

Once you reach a certain income level, however, you're not allowed to contribute to a Roth IRA. That amount can vary depending on your filing status, and there's even a phaseout range where you can still contribute but just not the full amount. A backdoor Roth IRA isn't a separate account but a strategy that allows people who can't contribute the full amount to a Roth IRA every year or at all to take advantage of the benefits of a Roth IRA.

The process of using the backdoor Roth IRA essentially involves transferring money from a traditional IRA to your Roth IRA—we'll cover that in more detail below.

Go over the information in the following table to understand the restrictions of a Roth IRA.

2021 Roth IRA Limits
Filing StatusModified Adjusted Gross IncomeHow Much You Can Contribute
Married filing jointly or qualified widow(er)Less than $198,000Up to the maximum ($6,000 for those under 50, $7,000 for 50+)
More than $198,000 but less than $208,000A reduced amount
$208,000 or moreZero
Married filing separately, and you lived with your spouse at any time during the yearLess than $10,000A reduced amount
$10,000 or moreZero
Single, head of household or married filing separately, and you did not live with your spouse at any time during the yearLess than $125,000Up to the maximum limit
More than $125,000 but less than $140,000A reduced amount
$140,000 or moreZero

Source: Internal Revenue Service

If you contribute more than you're allowed to, the IRS will charge a 6% penalty tax on the excess contribution for each year it remains in the account.

Pros and Cons of a Backdoor Roth IRA

Before you call your financial advisor or broker, however, it's important to note that there are immediate tax implications to consider before you complete a backdoor Roth IRA. There are also other potential pitfalls that could make your life more complicated.

Here's what to know about the benefits and drawbacks of using a backdoor Roth IRA.

Pros

  • Your contributions grow tax-free. With a traditional IRA, your funds grow tax-deferred, which means that when you take distributions in retirement, they'll be taxed as income. With a Roth IRA, however, you don't have to worry about taxes as long as your withdrawals meet IRS requirements.
  • You can withdraw your contributions. Most retirement accounts penalize all early withdrawals if you're not yet 59½ years old. But with a Roth IRA, you can withdraw up to the amount you've contributed to the account without taxes or penalties. This is because that amount has already been taxed.
  • There are no required minimum distributions. With most retirement plans, you have to start taking a minimum distribution amount once you reach age 72. But if you don't anticipate needing that money because you'll have enough income from other sources, moving it to a Roth IRA ensures that you don't have to take required minimum distributions and your contributions can continue to grow in the account.

Cons

  • You may get a big tax bill. Remember, when you make contributions to a traditional IRA, they're deductible on your tax return (unless your income exceeds the limit, at which point your traditional IRA contributions are not deductible). But if you deducted your initial contributions, you'll have to pay taxes on them and your gains if you convert your traditional IRA funds to a Roth IRA fund. Depending on how much you're converting, you could end up paying thousands or even tens of thousands of dollars in taxes.
  • There's a five-year waiting period. Even if you meet the age requirement to start taking qualified distributions, there's a five-year waiting period on all backdoor Roth IRA funds. If you take withdrawals of that money before the five-year period ends, you'll be taxed on the gains you've earned and get slapped with a 10% penalty on top of it—unless you qualify for an exception.
  • Things can get complicated. If you have other IRAs, including a SEP-IRA or SIMPLE IRA, you have to run some numbers to find a ratio of the money across all of your accounts that has already been taxed versus money that hasn't been taxed. You'll then pay your taxes based on that ratio. You might want to seek the help of a tax professional to figure this out.

Is a Backdoor Roth IRA Worth It?

A backdoor Roth IRA can be worth it if you can no longer make contributions to your Roth IRA, but you want to enjoy the benefits of the tax-free growth and lack of required minimum distributions. That said, most people likely won't need to worry about the Roth IRA income limits, so there may be no need to use this retirement strategy.

Even if you can benefit from a backdoor Roth IRA, you'll want to consider the tax implications for the current tax year. And if you're thinking about accessing that money anytime soon, forget about it. The penalty for breaking the five-year waiting period requirement can end up costing you.

Some alternative strategies include maxing out your 401(k) or other workplace retirement plan and your traditional IRA—even if you can't deduct the contributions. If you qualify for a health savings account (HSA), that can also be an excellent way to save for retirement on a tax-free basis. You'll be able to use HSA funds to cover medical expenses, which can be high for retirees.

How to Open a Backdoor IRA

Because a backdoor Roth IRA isn't a specific type of account, all you need to do is open a regular Roth IRA account. If you don't already have one, take some time to compare IRA providers to find the best fit for you.

Next, you'll make a contribution to your traditional IRA. Then you'll ask that your IRA provider transfer the money from your traditional IRA to your Roth IRA. You can also transfer funds that are already in your traditional IRA, but if you've earned any gains on those contributions, they'll be taxable.

If you weren't allowed to deduct your traditional IRA contributions, however, you won't owe any taxes unless the contributions have earned any gains.

Work With a Professional to Do It Right

If you're planning to use a backdoor Roth IRA, it's a good idea to consult with a financial advisor and a tax professional throughout the process. They can help you determine if a backdoor Roth IRA is the right move in your situation, take the right steps to perform a backdoor Roth IRA and plan for the potential tax bill.