Investing > Backdoor Roth IRA Explained

Backdoor Roth IRA Explained

Backdoor Roth IRAs allow you to contribute much more than you would normally be able to—but there’s a catch.

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Updated October 07, 2021

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Roth IRAs are great, right? Who doesn’t like tax-free growth and withdrawals? 🧾

However, an unfortunate fact tends to spoil the fun—high-income earners can’t contribute to Roth IRAs. The limits put in place by the IRS don’t exactly set a high ceiling—and while roundabout $208,000 is a great income for a household, it doesn’t place you in the category of the super-rich.

So, that’s that then, right? If you’re over the limit, you can’t do anything with a Roth IRA? Well…no, not exactly. You can make use of a backdoor Roth IRA—which is the topic we’ll be covering today.

Way back in 2010, the IRS removed income limits that dictated who can and who can’t convert a regular IRA to a Roth. If you’re familiar with these topics, the gears might already be spinning and the lightbulb in your head could already have lit up.

But just in case that hasn’t happened, let’s put it in the simplest terms—if you can’t contribute to a Roth IRA, you can contribute to a regular IRA—and then, you can convert it to a Roth. You will have to pay some taxes upfront, but after that, your money is free to grow unimpeded by the dreadful burden of taxes.

If you think you’re going to have more taxable income after you retire, or if you think that in the future, income taxes are going to rise (which they almost certainly will, at least a few times) you need to take a closer look at this strategy. It isn’t for everyone, and there’s a lot of small details that you should be mindful of, but if it is a good fit for you, it could end up saving you tens of thousands of dollars.

What you’ll learn
  • What is a Backdoor IRA?
  • Backdoor Roth IRA in 3 Steps
  • Pros and Cons
  • What is a Mega Backdoor Roth?
  • Rules to Keep in Mind
  • Pitfalls to Watch Out For
  • Is a Backdoor Roth Worth It?
  • The Backdoor Roth Strategy May Not Work
  • Conclusion
  • Get Started with a Broker

What is a Backdoor IRA? 💭

We realize that some of our readers might already be familiar with IRAs and Roth IRAs—but others might not be. So let’s start with a quick recap.

The Basics of Traditional IRAs and Roth IRAs 🧠

IRA stands for individual retirement account. IRAs offer tax advantages that make them a great vehicle for long-term investing. So, what’s the deal with Roth IRAs? Contributions to IRAs are made with pre-tax dollars (but they are tax-deductible), and your money grows tax-free—however, once you withdraw it, the money will be subject to income tax.

With Roth IRAs, contributions are made with after-tax dollars, and they aren’t tax-deductible. However, your investments grow tax-free, and in most cases, after the age of 59 and a half, you can make withdrawals without paying any additional taxes or incurring additional fees.

Sounds great, right? So why would anyone choose a traditional IRA over a Roth? Well, some people can’t contribute to a Roth IRA—and it has everything to do with their Adjusted Gross Income, or AGI. We’ll put a table down below for easy reference, and explain afterwards.

Tax FilingAdjusted Gross Income Maximum for Full Roth ContributionUpper AGI Limit
Single, household head, or married and filing separately if you haven’t lived with your spouse in the current year$125,000$140,000
Married and filing jointly / Widows and widowers who qualify for special filing status$198,000$208,000
Married but separately filed, on the condition that you lived with your spouse in the current year$0$10,000

The AGI maximum dictates the threshold under which you can make full contributions to a Roth IRA. The maximum contribution in 2021 is $6,000, or $7,000 if you’re over 50 years old. After you pass that threshold, you can only make partial contributions—less than $7,000 or $6,000, depending on how much over the threshold you are—and if you pass the upper AGI limit, you can’t contribute at all.

The Basics of Backdoor Roth IRAs 🤲

So, obviously, this strategy is geared toward investors who can’t make contributions to Roth IRAs. If you’re in that category, although you can’t put money into a Roth IRA, you can put money into a traditional IRA account, which has no income limits. 

That traditional IRA account can then be converted to a Roth IRA—sort of like funding a Roth account via the backdoor. Most of the top online brokerages that offer Roth IRAs and traditional IRAs will often help clients pull this strategy off.

Now, backdoor Roth IRAs aren’t exactly a bed of roses. There are tax implications to think about, especially if you already have some money stowed away in traditional IRA accounts—but we’ll get to that later

How to Make a Backdoor Roth IRA in 3 Steps

Now that we’ve covered and recapped the basics, let’s move on to concrete, actionable steps.

Consult a Professional 👔

First of all, we would highly recommend speaking to a qualified professional before you take any further steps. Doing a backdoor Roth IRA isn’t complicated—in fact, you can almost certainly do it on your own—but there’s a lot of minutiae, details, and pitfalls that you’re probably not aware of.

Keep in mind that this is a common procedure—it isn’t anything out of the ordinary, so getting the down-low of whether it’s a good choice for you from a professional shouldn’t take too much time.

Fund an IRA Account 👤

If indeed a backdoor Roth IRA is the way to go for you, the first thing that you’ll need to do is to open and fund a regular IRA account with a top broker. If you already have one, you can use it—but doing so always comes with a tax bill. 

At least for the first time, we’d counsel opening a new account and funding it with nondeductible contributions. Don’t forget that you have to file IRS Form 8606 as well.

Convert the Account to a Roth IRA 👥

Once that is done, you move on to the actual conversion. Your IRA provider should give you the necessary paperwork and documentation. If both of the accounts are from the same provider, this is a relatively quick and simple transfer. If the providers are different, you’re going to have to request a trustee-to-trustee transfer—but this also isn’t too time-consuming.

If your IRA provider doesn’t support the transfer of funds, you can request a check. However, you’re going to have to deposit it with the Roth IRA within two months in order to avoid early withdrawal penalties and tax implications.

You’ll want to do the conversion as soon as possible. If the nondeductible contributions you’ve made accrue investment gains, you’ll owe taxes on them.

Advantages and Drawbacks of a Backdoor Roth IRA ⚔️

The advantages of a backdoor Roth IRA are apparent—it allows you to enjoy the benefits of tax-free capital appreciation as a high-income earner. In the long run, this is a huge boon—and a backdoor Roth IRA can significantly contribute to your retirement plans, especially if you construct a portfolio with high growth potential—think carefully picked growth stocks or exchange-traded funds

Tax-differences-between-an-IRA-and-a-Roth-IRA
A Roth IRA can help you avoid capital gain tax after your portfolio has grown. This makes it a good choice for young people with decades of capital growth in front of them.

On top of that, Roth IRAs allow heirs and spouses to make tax-free withdrawals in a period of five years should you pass away—giving you a little extra security in knowing that your loved ones will be provided for should the worse come to pass.

Roth IRAs also don’t have required minimum distributions like traditional IRA accounts do—you can withdraw as much or as little as you need to when you need to. If you think tax rates are going to go up in the following years, or if you believe that you’ll be in a higher tax bracket when you retire, backdoor Roth IRAs are a fantastic choice.

The biggest drawbacks with backdoor Roth IRAs are the tax bills you might be subject to. If you convert an existing IRA to a Roth, all the deductions that you made use of will have to be repaid. Additionally, all the money that you convert will be counted as income—and this might very well push into a higher tax bracket. You’re also going to have to keep the notorious pro-rata rule in mind—but we’ll cover that in detail in a later section of this guide.

What is a Mega Backdoor Roth? 🚪

Before we move on to some of the nitty-gritty details regarding backdoor Roth IRAs that you’ll have to keep in mind in order to execute this strategy successfully, let’s take a small yet important detour.

Backdoor Roth IRAs are available to everyone. They’re simple to pull off, and if they make sense for your specific circumstances, they’re a no-brainer. However, there is a way to contribute even more to a Roth IRA through the backdoor—but only if you meet a very specific set of criteria. 

Even so, this strategy, called a mega backdoor Roth, can make a huge difference in your retirement plans—so give it a closer look to see if you qualify. And even if you don’t—who knows, one day you might.

What is a 401(K) Plan
The tactic is called the mega backdoor Roth IRA because it allows you to move a massive amount of cash into a Roth IRA every year.

Let’s start with the basic criteria. In order to be able to do a mega backdoor Roth conversion, you need a 401k plan at work that allows after-tax contributions while also allowing in-service withdrawals and rollovers.

The amount that you can contribute to a 401ak account pre-tax is $19,500. However, if your plan supports it you can also contribute $38,500 in after-tax dollars. If your plan also allows for in-service rollovers, you can roll over that amount to a Roth IRA—allowing you to give a sizable boost to your investments that will experience tax-free growth.

However, these criteria aren’t all too common. If your 401k plan doesn’t support all of the necessary requirements, you could try talking to higher-ups and HR—but we wouldn’t hold our breath.

Backdoor Roth IRA Rules to Keep in Mind 🤔

Now, let’s take a step back and return to our regular, good old-fashioned backdoor Roth IRA—and the rules that you should always keep in mind when executing this strategy.

The Five Year Rules 📅

The five-year rules (yes, rules, there are two of them) both deal with withdrawals. The first applies to all Roth IRAs—even if you’re over the age of 59 and a half, you cannot withdraw your earnings tax-free and without paying penalties unless your first deposit to the Roth IRA account had been made more than five years ago.

The second five-year rule applies specifically to backdoor Roth IRAs or Roth conversions. When you make a conversion to a Roth IRA, you cannot withdraw those funds for five years—and this applies every time you execute the backdoor strategy. In practice, this means that if you take advantage of this method multiple times, you’re going to have to withdraw your funds bit by bit—but if you’re older than 59 and a half, you’re exempt from this rule.

Backdoor Roth Conversion Taxes Depending on Your State

The tax bill that you’ll have to foot when executing the backdoor Roth IRA strategy will vary depending on which U.S. state you live in. While most states treat conversions as income, others exclude a portion or the entirety of the conversion from your tax bill. This leads us to our next rule.

Talk to a Professional and Keep the Mega Backdoor Roth in Mind 📝

Executing a backdoor Roth IRA is simple—even more so as a lot of brokers will gladly assist you. However, by now it should be obvious that there are a lot of complex details under the surface of this simple procedure that can have a huge effect on the final outcome.

Even though you can most likely do this stuff on your own, we highly advise against it. Running the idea of a backdoor Roth IRA by a professional will help you ascertain whether it is a good decision for you, how to reduce the tax burden, and how much money you should put in through the backdoor for optimal results.

On top of that, a professional can help you make sense of the various requirements that have to be met for executing a mega backdoor Roth conversion—although they are rare as we previously stated, you should check just in case—it’s too good of an opportunity to simply let slip by, and checking whether or not you meet the criteria is simple.

Backdoor Roth Pitfalls to Watch out For 🔍

Alright, now that we’ve covered the most important rules that govern how you should approach backdoor Roth IRA conversions, let’s take a look at some of the potential pitfalls of this strategy—what they are, how to avoid them if possible, and if not, how to mitigate them.

Get Ready for a Tax Bill 💲

You’re most likely going to have to pay taxes at some point in the entire process. If the conversion process bumps you up to a higher tax bracket, this could have wide-ranging implications on your finances in the following period. This is one of the main reasons why we suggest always running the idea of a backdoor Roth by a professional before going forward with it.

If you’re opening a new IRA account in preparation for this maneuver, we recommend investing the money in securities that will hold their price and have little chance of accruing gains before you finish the conversion.

The Dreaded Pro-Rata Rule 💰

Before we move on to the actual Pro-Rata Rule, which can be a bit technical-sounding and hard to grasp, let’s set the stage. If you have existing IRA assets, including those in a SEP or SIMPLE IRA, you should proceed with backdoor Roth IRAs very carefully, and consult a professional—we cannot stress this enough. You don’t want to skip that part—it could end up costing you thousands of dollars.

The IRS looks at all your IRAs as a single account—even if you have multiple accounts. To put it in the simplest possible terms, the Pro-Rata Rule looks at the percentage of untaxed money in your IRA accounts and applies that percentage to your Roth IRA conversion when it comes time to foot the tax bill.

Backdoor Roth IRA explained
A backdoor Roth IRA lets you convert a traditional IRA to a Roth, even if your income is too high for a Roth IRA.

Let’s use a hypothetical scenario that will hopefully clear up any confusion. Say for example that you have $54,000 in pre-tax dollars across your traditional IRA accounts. You open a new IRA account, fund it with 6,000 after-tax dollars, and then execute the backdoor Roth IRA maneuver.

In the eyes of the law, you have a grand total of $60,000 in IRAs—the $6,000 that you backdoored is 10% of that total. That percentage is applied to the backdoored sum, meaning that out of your $6,000, only $600 is converted tax-free—and as for the rest, you’ll have to pay income tax at your regular bracket.

Consequences on Social Security and Medicare 🛡️

If you’re receiving benefits from government programs such as Social Security or Medicare, performing a backdoor Roth IRA can have an impact on your benefits. If this strategy puts you in a higher income-tax bracket, your social security benefits might become taxable, or if they already are, a higher percentage could become taxable.

As for Medicare, monthly premiums for Medicare Part B and Medicare Part D are based on your Modified Adjusted Gross Income or MAGI from two years ago. Medicare Part B covers outpatients treatment, trips to the doctor, and tests, while Medicare Part D covers prescription drugs—depending on the state of your health, higher premiums could result in significantly higher healthcare costs overall.

Spreading Out Your Contributions 💸

Spreading out the contributions that you’ll roll over into a Roth IRA is a mistake—period. Not only is it more hassle, but it also makes paperwork more confusing, incurs additional transaction costs that you’ll have to cover, and makes it more likely that the assets in your account will accrue gains that will result in a larger tax bill. Don’t do the backdoor Roth IRA trick bit by bit—do it all at once.

Tax Form 8606 🤑

We’ve already mentioned this particular form before, but it bears repeating—not including form 8606 in your taxes is both illegal, and could very easily wind up costing you more in taxes.

Is a Backdoor Roth Worth Setting Up? 💳

So, is the Backdoor Roth IRA method right for you? As we’ve discussed earlier, although it seems like a no-brainer at first glance, this strategy isn’t a good fit for everyone.

First things first, if you’re eligible for Roth contributions, there’s no need to go about things in a roundabout way—simply contribute to your Roth IRA. If you’re planning on using the funds that you would put in a backdoor Roth within the next five years, you’d better look elsewhere—the Roth IRA 5-year rule and the tax implications of conversion make this strategy only suitable in the long term.

If you can’t cover the tax bill associated with the conversion to a Roth IRA without dipping into the funds you’ve already put into retirement, you shouldn’t use this strategy. Even a small amount of money removed from a retirement account can have a big impact on the final result of your portfolio years down the line, and you’re exposing yourself to a 10% penalty for early withdrawal.

On the other hand, if you don’t qualify for Roth IRA contributions, you’ll want to seriously consider the backdoor route. If you can afford the taxes associated with conversion without dipping into your IRAs, then the benefits that years of tax-free growth will provide far outweigh the cost of the tax bill.

Roth IRAs have the added benefit of no required minimum distributions, and they also allow you to withdraw money more easily (as long as you’ve passed the five-year mark since contributing).

With all that said, the specifics of your financial situation are beyond our ken. There are other factors to consider, so make sure to talk to a financial professional that specializes in retirement and taxes.

The Backdoor Roth Strategy May Not Work in the Future 💵

Although backdoor Roth IRA’s are perfectly legal (they’re not even in a gray area as far as the law is concerned), that doesn’t mean that the status quo will be upheld forever. Most notably, the IRS hasn’t actually tackled the topic and has remained strangely silent about backdoor Roth IRAs.

Just the SECURE Act of 2019 changed the laws regarding retirement contributions and eliminated the Stretch IRA, there is a possibility that future legislation will prevent investors from making use of this particular strategy. So, what would happen to backdoor Roth IRAs if that were to be the case?

Well, it’s anyone’s guess. Investors who used this method might be subject to an excise tax, fines, or might even go unscathed because of a potential grandfather clause. There has been no word on restricting access to backdoor Roth IRAs, however, seeing as how the Biden administration is taking clear steps toward higher taxation, it wouldn’t come as a massive surprise.

Be that as it may, there’s no trace of backdoor Roth IRA restrictions in the Secure Act 2.0, so at least for now, we can rest easy. Even though there is a non-zero chance that investors who use backdoor Roth IRAs will face some sort of penalty, there is an almost certain chance that the government is going to increase income taxes in the future—regardless of whether Democrats or Republicans are in office.

The fact of the matter is simple—the mounting deficit and the damage caused by the COVID-19 pandemic will force the government to raise more money than it currently does—and we’re not even taking into account 2021’s $1 trillion infrastructure bill, which is also a strain on the budget.

Conclusion 🎬

If you’ve made it this far, we hope that we’ve been able to explain the most important factors regarding backdoor Roth IRAs without it being dreadfully boring. Although the basic precepts are simple, there are a lot of small details to watch out for—and as they say, the devil is in the details.

If you’re a high-income earner or plan on being one in the future, being acquainted with this investment method is a great way to make use of your hard-earned dollars for a financially secure and enjoyable retirement.

Backdoor Roth IRA: FAQs

  • Is a Backdoor IRA Legal?

    Yes—Backdoor IRAs are perfectly legal as of 2021. However, you should keep an eye out for proposed changes in legislation just to be on the safe side.

  • Can I Do a Backdoor Roth Every Year?

    Yes—in fact, you can do multiple backdoor Roth conversions within a single year if you so desire.

  • How Do You Report a Backdoor Roth on Your Tax Return?

    Backdoor Roths are reported via tax form 8066 on your tax returns.

  • Is a Backdoor Roth a Recharacterization or a Conversion?

    A Backdoor Roth is a conversion—recharacterizations were made illegal when the Tax Cuts and Jobs Act passed in 2017.

Get Started with a Broker

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Account Types
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Accounts & Fees
Management fees

0.25%

0.05% - 0.3%

Account Minimum

$0

$50,000

Account Types
  • Cash account
  • Traditional, Roth, SEP, & rollover IRAs
  • Joint and individual and non-retirement accounts
  • Trusts
  • Brokerage accounts - individual and joint
  • Traditional, Roth, SEP, rollover, & SIMPLE IRAs
  • Trusts
General
Best for
  • Hands off investors
  • Retirement accounts
  • Acounts with high balances
  • Human advisors
Promotion

1 year of free management, with qualifying deposit

None

Human advisor?

Yes, but only with Betterment Premium (0.40% fee)

Rating
Accounts & Fees

Management fees

$1, $2, or $3/month

0.25%

0.05% - 0.3%

Account Minimum

$5

$0

$50,000

Account Types

  • Individual non-retirement accounts
  • Traditional & roth IRAs
  • Cash account
  • Traditional, Roth, SEP, & rollover IRAs
  • Joint and individual and non-retirement accounts
  • Trusts
  • Brokerage accounts - individual and joint
  • Traditional, Roth, SEP, rollover, & SIMPLE IRAs
  • Trusts
General

Best for

  • Hands-off investing
  • Investors who have difficulty saving
  • Hands off investors
  • Retirement accounts
  • Acounts with high balances
  • Human advisors

Promotion

None

1 year of free management, with qualifying deposit

None

Human advisor?

Yes, but only with Betterment Premium (0.40% fee)

All reviews, research, news and assessments of any kind on The Tokenist are compiled using a strict editorial review process by our editorial team. Neither our writers nor our editors receive direct compensation of any kind to publish information on tokenist.com. Our company, Tokenist Media LLC, is community supported and may receive a small commission when you purchase products or services through links on our website. Click here for a full list of our partners and an in-depth explanation on how we get paid.

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