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Understanding The Backdoor Roth IRA & How To Set One Up

When you consider building your nest egg, Roth options can be extremely valuable. Specifically, when it comes to Roth IRAs, one of the greatest benefits is they allow qualified investors to enjoy tax-free withdrawals of their money. A backdoor Roth IRA allows people with high incomes to sidestep the Roth’s income limits.

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

What Is a Backdoor Roth IRA?

A Backdoor Roth IRA 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.

An important consideration is your Modified Adjusted Gross Income (MAGI) and tax-filing status (single, married filing jointly, married filing separately). This will determine if you are eligible to contribute to a Roth IRA.

  • If you file taxes as a single person, your MAGI must be under $140,000 for tax year 2021 to contribute to a Roth IRA. (You can contribute fully only if your income is under $125,000. Those with income between $125,000-$140,000 can contribute incrementally less as their income increases.)
  • If you’re married and file jointly, your MAGI must be under $208,000 for tax year 2021. (You can contribute fully only if your combined income is under $198,000. Those with income between $198,000-$208,000 also have incrementally lower contribution thresholds.)

The maximum total annual contribution for all your IRAs combined is:

  • $6,000 if you’re under age 50
  • $7,000 if you’re age 50 or older

If your current MAGI exceeds the limit given your tax filing status, you may be able to leverage Backdoor Roth conversion for your retirement savings.

How to Create a Backdoor Roth IRA

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

  • Make a nondeductible, traditional IRA contribution. Unlike a Roth IRA, the traditional IRA has no income ceiling for contributions.
  • 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).
  • 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:

  • 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.
  • 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.

Interested in ways to optimize your investments for taxes? Get our free guide 5 Tax Hacks Every Investor Should Know. When you download the guide, you get immediate access to Personal Capital’s free financial Dashboard.

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Rules to Know

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.

Is a Backdoor Roth IRA Right For You?

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

  • You may not need a Backdoor Roth Conversion 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.
  • 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.
  • You should be willing 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.
  • You may want to keep the money in the traditional IRA if you are in a high tax bracket now and expect to be in a lower tax bracket upon retirement.
  • If you plan to relocate to a lower income tax state or a state where there are no income taxes.

Backdoor Roth IRAs are worth considering for your retirement savings, especially if you are a high income earner. A Backdoor Roth conversion can be something to consider 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!)
  • Do not have other pre-tax IRA assets

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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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