Using a tax-free Roth to save for retirement is a smart move, but the Roth IRA door gets slammed in your face if you make too much money. Laura explains how high earners can still have one using a backdoor Roth IRA strategy.
Jana S. asked this question recently about Roth IRAs:
I just listened to your podcast about what to do if you overcontribute to a tax-advantaged account, especially when you earn too much to qualify for a Roth IRA. I’m interested in how to do a backdoor Roth. What are the rules that apply for transferring funds from a traditional IRA to a Roth?
If you’re a regular Money Girl reader or podcast listener, you’ve heard me discuss the fantastic tax benefits of a Roth IRA. The problem is, as Jana mentioned, the door to a Roth IRA gets slammed in your face if you make too much money.
But sometimes when you can’t get in the front door, the backdoor is wide open! In this episode, I'll explain a strategy known as the backdoor Roth or Roth conversion. We’ll cover how high earners can have a Roth IRA without breaking the rules.
What is a Roth IRA?
A Roth IRA is a retirement account for individuals that’s never taxed after you make contributions. Instead of getting an upfront tax deduction (like you do with deductible contributions to a traditional IRA), you can withdraw Roth IRA contributions and earnings entirely tax-free as long as you’ve had it for at least five years and reach age 59.5.
You can make IRA contributions as long as you have earned income and no matter your age, although you can’t contribute more to an IRA than you earn. To contribute the maximum for 2021, which is $6,000 or $7,000 for those over age 50, you must make at least that much.
For 2021, single taxpayers must have an adjusted gross income of $125,000 or less to make a full Roth IRA contribution.
But, as I mentioned, not everyone qualifies for a Roth IRA. For 2021, single taxpayers must have an adjusted gross income of $125,000 or less to make a full contribution. And married couples who file joint taxes must earn $198,000 or less. If your income exceeds these annual limits, you can keep an existing Roth IRA, but you can’t make new contributions.
Note that if you have a Roth at work, such as a Roth 401(k) or 403(b), there are no income limits to qualify. Unlike a Roth IRA, you can max out these accounts every year no matter how much you earn.
What is a backdoor Roth IRA?
A backdoor Roth isn’t a type of retirement account, it’s a method for high earners to fund a Roth IRA even when they don’t qualify for regular contributions. If your income is below the annual Roth IRA threshold, you don’t need a backdoor Roth because you can make regular "front door" contributions.
In addition to tax-deductible contributions, you can also make nondeductible, taxable contributions to a traditional IRA. Interestingly, the IRS allows you to convert nondeductible IRA contributions to a Roth IRA, which is the “backdoor” concept. It's a clever and legitimate way to move money into a Roth IRA, even if you earn too much to qualify for one.
A backdoor Roth isn’t a type of retirement account—it’s a method for high earners to fund a Roth IRA even when they don’t qualify for regular contributions.
To create a backdoor Roth IRA, you must make a nondeductible (taxable) contribution to a traditional IRA and file IRS Form 8606, Nondeductible IRAs. Then you roll over those funds into a Roth IRA. You won't owe taxes, except on any investment growth in the account earned between the time of your traditional IRA contribution and the Roth conversion. If it was a short period, your earnings and resulting tax should be small. Once your funds are in a Roth IRA, the earnings can grow and be withdrawn tax-free in retirement.
As I mentioned, there’s no income limit for traditional IRA contributions. So, converting nondeductible contributions from a traditional IRA to a Roth IRA allows anyone, regardless of income, to fund a Roth IRA.
Problems with doing a backdoor Roth IRA
Though sneaking into a backdoor Roth IRA sounds great, it doesn’t always work as planned.
If you already have pre-tax money in a traditional IRA, tax must be prorated over all your IRAs.
The IRS requires you to lump all your IRAs together when you make a distribution and doesn’t allow you to cherry-pick one account to convert. So, if you already have pre-tax money in a traditional IRA, tax must be prorated over all your IRAs.
For example, let’s say you have $5,000 in a nondeductible IRA that you want to convert into a Roth IRA, and you also have $15,000 in a deductible IRA. Since you have a total of $20,000 in IRAs, the $5,000 nondeductible portion is 25% ($5,000 / $20,000 = 0.25 or 25%) and the taxable portion is 75% ($15,000 / $20,000 = 0.75 or 75%).
You must pay the same ratio of tax on the conversion. In other words, 75% of $5,000, or $3,750, would be subject to tax. It’s up to you to weigh the upfront tax liability against the future benefits of getting tax-free withdrawals from a Roth IRA.
However, if you don’t have any pre-tax IRA funds, you could convert the full $5,000 from a nondeductible IRA into a Roth IRA with no tax due. Yes, this gets complicated. Just remember that if you have a substantial amount of pre-tax funds in a traditional IRA, doing a backdoor Roth IRA doesn’t help you avoid additional tax. Unfortunately, you can’t convert just nondeductible funds and forget about your pre-tax amounts.
Workaround for doing a backdoor Roth IRA
If you really want to do a backdoor Roth IRA, and you have a retirement plan at work, you can use it as a workaround solution. You could remove your pre-tax IRA money from the equation by rolling it over into your 401(k) or 403(b). That would leave you with just nondeductible, after-tax IRA money to convert to a Roth.
High earners who fund a backdoor Roth IRA still won't qualify to make new contributions to the account, but the converted funds grow tax-free, which could save a bundle.
This strategy only works if your workplace plan allows incoming IRA rollovers. Plus, make sure you're happy with the plan's investment choices and fees because you don't have as much control over a 401(k) as you do with an IRA. If you're self-employed, you could set up a solo 401(k) that allows roll-ins and move your pre-tax IRA money into it.
Remember that high earners who fund a backdoor Roth IRA still won't qualify to make new contributions to the account. However, the converted funds grow tax-free, which could save a bundle in taxes. Additionally, Roth IRAs don't have required minimum distributions (RMDs), which means you can keep them indefinitely.
Doing a backdoor Roth can be worthwhile if you can afford to pay a potentially significant tax bill on your converted balance.
Consider that your converted funds count as income for tax purposes, which could move you into a higher tax bracket for that year. Plus, it's a transaction that you can't undo if you change your mind later on. So be sure to speak to a tax or financial advisor about the pros and cons of a backdoor Roth before crossing the threshold.