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The Ins and Outs of Backdoor Roth IRAs

Daniel Jackson, CFP® |

One of the Roth IRA’s biggest benefits is tax-free withdrawal of money in retirement. When I bring this up to clients and friends, many know about this advantage but they lament the fact that they cannot contribute to a Roth IRA due to income limit restrictions. While it is true that high earners are unable contribute directly to a Roth IRA, the backdoor Roth IRA is a way to bypass these income limits. In this article, let us dive deeper into this strategy and how it may apply to you!

The Backdoor Roth IRA

The backdoor Roth IRA is simply a regular Roth IRA that has been funded with the conversion of a nondeductible traditional IRA. When done correctly, this conversion does not have any tax consequences. This “backdoor” way of funding a Roth IRA allows high income earners to still enjoy the tax benefits of Roth IRAs even if they are unable to contribute to it directly.

The Roth IRA Contribution Limits

The graph below shows the Roth IRA Contribution Limits for 2024:

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Traditional IRAs vs Roth IRAs

Before we get into the steps of the backdoor Roth IRA strategy, it is important to understand the differences between the Traditional IRA and the Roth IRA. The traditional IRA is advantageous because it can give an immediate tax break due to the ability to take a tax deduction on the contributions. In other words, it is funded with “pre-tax dollars.” The investor also enjoys tax-deferred growth on these dollars while the money is in the traditional IRA. Please note: this deduction may be limited if you or your spouse is covered by a retirement plan at work and your income exceeds certain levels. (https://www.irs.gov/pub/irs-pdf/p590a.pdf). At withdrawal of the traditional IRA, normally in retirement, Uncle Sam comes knocking and it is time to pay taxes - contributions and earnings are taxed as ordinary income. Depending on the amount of money withdrawn, this can be a significant amount owed in taxes.

The Roth IRA differs from the traditional IRA because it is funded with “after-tax” dollars. The investor does not get the immediate tax break of a tax deduction in the year they fund a Roth IRA, but like the Traditional IRA they still enjoy the tax-deferred growth on the contributions.  It is at withdrawal where a Roth IRAs is tax-advantageous when compared to the traditional IRA. Qualified withdrawals from a Roth IRA are tax free to the investor. It is important to note here, that since this account is funded with after-tax dollars, you are allowed to make withdrawals of the contributions to a Roth IRA tax-free at any time. A qualified withdrawal of Roth IRA earnings is one where the investor is over age 59½ and has held a Roth IRA for at least 5 years. Since the investor forwent the tax break up front, they are getting this tax advantage on the back end at withdrawal. My colleague David wrote a more in-depth article about the difference between traditional and Roth IRAs, found here.  In summation, the biggest distinction between the traditional IRA and Roth IRA is when the accounts are taxed.

The Steps to Execute a Backdoor Roth IRA:

  1. Contribute to a nondeductible Traditional IRA

The first step is funding a traditional IRA. For 2024, the annual contribution limit for both IRAs and Roth IRAs is $7,000, ($8,000 if you age 50 or over). It is important you do not claim a tax-deduction when you make this contribution.

  1. Convert Traditional IRA to Roth IRA

Once you have funded your traditional IRA, you will convert that contribution to your Roth IRA. By not claiming a tax-deduction in step 1, you will still be dealing with “after-tax” dollars and the conversion will be a non-taxable event.

  1. Watch out for Pro-Rata Rule

Back Door Conversions are only tax free if you do not have any pre-tax IRA dollars. If you have a pre-tax (Traditional, SIMPLE, SEP) IRA you need to be aware of the pro-rata rule. This is an IRS rule that determines how much of your conversion is subject to taxes. In the example below, the investor funded a traditional IRA with $35,000 over 5 years and the account has grown to $40,000. In year 6, the investor wants to use the backdoor Roth strategy with their $7,000 nondeductible IRA contribution. The investor adds the total value of the pre-tax IRA plus the nondeductible contribution and divides that amount by the pre-tax IRA amount. In this example, 85.1% of the investor’s conversion to the Roth IRA is taxable. If you do not have any pre-tax IRAs, then the pro-rata rule does not apply, and the full amount of your nondeductible contribution can be converted without paying taxes.

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4. Consult your Accountant to file Form 8606

The Form 8606 (https://www.irs.gov/forms-pubs/about-form-8606) reports nondeductible contributions and distributions from traditional, SEP, or SIMPLE IRAs. While it may be that you do not owe taxes by completing a backdoor Roth IRA, you must disclose the nondeductible contributions and Roth IRA conversion when you file your taxes. Please consult a tax professional if you have any questions concerning this step.

  1. Repeat Annually

There is no limit to the amount of the times you can convert funds from an IRA to a Roth IRA. If the backdoor Roth IRA remains a viable strategy for your financial situation, continue to repeat this process annually!

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Benefits of the Backdoor Roth IRA

I’ve listed 5 steps, some rules to watch out for, and an additional tax form to file… so why does someone want to deal with this backdoor Roth strategy?

  1. Qualified Withdrawals are Tax Free

You will pay no tax on the principal or earnings when you make a qualified withdrawal from a Roth IRA.

  1. No Required Minimum Distributions

Roth IRAs are not subject to Required Minimum Distributions, because you already paid the income taxes due on the money. This means that a Roth IRA can grow tax-deferred during your entire lifetime.

  1. Estate Planning

This can be greatly beneficial for estate planning if you want to pass this account along to your heirs. The account can grow tax-deferred during your lifetime, then when your heirs inherit the account, they will be able to make tax-free withdrawals from the Roth IRA over the span of 10 years.

  1. Tax Diversification

At RPJ, we think it’s a good idea to have multiple tax-advantageous accounts. Pre-tax IRAs & qualified plans are beneficial if you believe that you’ll be in a lower tax bracket upon retirement. That way you can defer paying taxes until you withdraw from these accounts in retirement. However, if you’re unsure of where your tax bracket will be, it is beneficial to have multiple options available. The fact of the matter is the US National Debt is over $34.5+ trillion. (https://www.usdebtclock.org/) Given that fact, I don’t see how politicians can meaningfully lower taxes in the decades to come. By having multiple accounts with various tax-advantages, you are giving yourself options to make the prudent decision for your financial situation when you need to.

By reading this article, I hope you’ve gained some insight into the backdoor Roth IRA. Please reach out if you have any questions or would like to discuss this further!

 

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