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Is a Backdoor Roth IRA Right for You? What It Is and How to Convert

When you consider your retirement and the investment vehicles you use to build your nest egg, Roth options can be extremely valuable. Specifically, when it comes to Roth IRAs, one of the greatest benefits is they allow investors who qualify to enjoy tax-free withdrawals of their money.

In addition, Roth IRAs don’t have required minimum distributions (RMDs), so you could see tax-free growth for as long as you are alive. You could take out as much or as little as you want when you want, or leave it all for your beneficiaries.

Like many things in life, there are limitations. Some individuals may not be qualified to open or contribute to a Roth IRA. An important point to keep in mind is your Modified Adjusted Gross Income (MAGI) and tax-filing status (single, married filing jointly, married filing separately) will determine if you are eligible to contribute to a Roth IRA for 2021.

For 2021, the following guidelines are in place to determine eligibility for Roth IRA contributions:

  • For those married and filing jointly, if your 2020 MAGI is below $196,000, you can contribute up to the yearly maximum of $6,000. For those age 50 or older, that maximum yearly amount increases to $7,000. The contribution limit to a Roth IRA begins to phase out and decreases for married households that have a MAGI between $196,000 and $205,999, and those who report more than $206,000 in MAGI are ineligible to contribute to a Roth IRA.
  • Married couples who file separately and report MAGI levels exceeding $10,000 will not be eligible to contribute to a Roth IRA, whereas those who report a MAGI below $10,000 will be able to contribute at a reduced level. Tax filers who report as head of household or married filing separately, but have not lived with their spouse in the past year will be able to follow the below limits and rules for singles.
  • Single tax filers who have a 2020 MAGI below $124,000 will be able to contribute up to the maximum amount of $6,000 (increases to $7,000 if you are age 50 or older). The contribution limit begins to phase out for single filers who report MAGI levels between $124,000 and $138,999, while those who report more than $139,000 for their MAGI will not be eligible for a Roth IRA contribution.

If your current tax filing status and MAGI exceeds the limit, you may assume that you are unable to use a Roth IRA as an investment vehicle, but one thing to be aware of is the possibility of using a Backdoor Roth Conversion.

>>Read More: Roth IRA vs. Roth 401k: How are They Different?

What a Backdoor Roth Conversion Is and How to Accomplish One

A Backdoor Roth Conversion essentially lets you convert your nondeductible traditional IRA contribution to a Roth IRA, even if your income is too high to make a Roth IRA contribution. If performed correctly, the Backdoor Roth Conversion does not have tax consequences. The Backdoor Roth Conversion is a way for high income earners to have the ability to build Roth IRAs assets.

To perform a Backdoor Roth Conversion, you can follow the below steps:

  1. Make a nondeductible, traditional IRA contribution. Unlike a Roth IRA, the traditional IRA has no income ceiling for contributions.
  2. Convert the nondeductible IRA contribution to your Roth IRA. If there are no earnings on the converted funds, then the conversion is a non-taxable event (unlike if you were to convert pre-tax IRA funds into a Roth, in which case you pay taxes on the converted amount at your current ordinary income rate).
  3. Repeat annually, as long as this strategy remains appropriate for your financial situation.

It is encouraged you work with a tax professional and your financial advisor prior to executing a Backdoor Roth Conversion, as there may be some instances where you will need to pay taxes:

  1. If you included pre-tax IRA assets in the conversion. If you deducted your Traditional IRA contributions and then decided to convert your traditional IRA to a Roth IRA, you’ll need to pay taxes on the pre-tax assets. When it comes time to file your tax return, be prepared to pay income tax on the pre-tax money you converted to a Roth.
  2. If you have other pre-tax IRA assets remaining after your Backdoor Conversion. This is known as the Pro Rata rule, which we discuss below.

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Rules to Know: Pro Rata Rule

As with many financial vehicles, there are notable rules to keep in mind in order to avoid having the need to pay penalties. The most important one to know before executing a Backdoor Roth Conversion is the Pro Rata Rule.

The Pro Rata Rule is an IRS rule that determines what amount is subject (or not) to taxes when you convert IRA dollars from a Traditional IRA to a Roth IRA. To put it simply, if you attempt to convert after-tax Traditional IRA contributions to a Roth IRA, but there are existing pre-tax IRA dollars, you will be subject to taxation on a prorated basis.

When determining your tax bill on a conversion from a traditional IRA to a Roth IRA, the IRS is going to look at all of your IRA accounts combined. For example, if all of your IRAs combined consist of 80% pre-tax money and 20% after-tax money, that 80/20 ratio determines what percentage of the after-tax money you convert to a Roth is going to be taxable. For this specific example, no matter how much money you convert or which pre-tax IRA account you pull the money from, 80% of the amount you convert to the Roth will be taxable. The IRS applies the pro-rata rule to your total IRA balance at year-end, not at the time of conversion.

Why the Backdoor Roth Conversation May Not Be for You

Depending on several factors, the Backdoor Roth Conversion may not fit everyone’s financial strategies and goals.

  1. If you are able to meet your savings goals with the maximum retirement limit through your workplace retirement account and are not planning on additional retirement savings, you may not need a Backdoor Roth Conversion.
  2. If you already have pre-tax money in a traditional IRA, because of the pro rata rule, it may not end up being advantageous from a tax perspective to convert.
  3. If you are unwilling to keep the funds in the newly created Roth IRA for at least five years before withdrawing the money. If funds are withdrawn earlier, you may have to pay taxes on any earnings and potentially will incur a 10% penalty unless you are age 59 ½ or older.
  4. If you are in a high tax bracket now and expect to be in a lower tax bracket upon retirement, you may want to keep the money in the traditional IRA.
  5. If you plan to relocate to a lower income tax state or a state where there are no income taxes.

Why a Backdoor Roth Conversion Could Be Right for You

Backdoor Roth IRAs are certainly something to consider when you’re mapping out your retirement savings, especially if you are a high income earner. Namely, if you’ve already maxed out other retirement savings options, are willing to leave the money in the Roth for at least five years (ideally longer!), and do not have other pre-tax IRA assets, then a Backdoor Roth Conversion can be something to consider.

Suggested Next Steps for You

  1. Get in touch with one of our fiduciary financial advisors in order to get tailored advice on investing practices for your financial goals.
  2. Sign up for Personal Capital’s free financial tools to get a complete 360-degree view of your finances all in one place.

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The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting or investment advice. You should consult a qualified legal or tax professional regarding your specific situation. Keep in mind that investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.

Any reference to the advisory services refers to Personal Capital Advisors Corporation, a subsidiary of Personal Capital. Personal Capital Advisors Corporation is an investment adviser registered with the Securities and Exchange Commission (SEC). Registration does not imply a certain level of skill or training nor does it imply endorsement by the SEC.

Dan Kellogg, CFP®, RICP® is a Senior Financial Advisor and Financial Planning Income Specialist at Personal Capital.
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