The Roth IRA is one of my top three favorite types of accounts for retirement savings due to the many long-term tax benefits Roth IRAs provide. Unfortunately, contributing directly to a Roth IRA isn’t available to everyone. If you either don’t have enough earned income or your income, in general, is too high, you will not be able to contribute directly to a Roth IRA. There are no income limits to be able to make non-deductible Traditional IRA contributions or to perform Roth conversions, though.
So for those of you high-income earners who make too much, there is a nice little planning workaround to consider. Assuming you don’t have other large IRA balances (see Pro-Rata Rules below), you can take advantage of the aforementioned opportunities in the tax code by making what’s known as a Backdoor Roth IRA contribution instead.
Why You’d Want to Contribute to a (Backdoor) Roth IRA
As we’ve discussed previously, any type of Roth account (401k, 403b or IRA) allows you to grow some of your retirement savings tax-free (aside from the tax you pay on the contributions, which you’d be paying regardless), if used appropriately. Why does this matter? Essentially, it’s as if you’re saving the contribution amount as well as the future taxation on the growth of the contribution at the same time. So with a Roth IRA, you’re actually saving more in the long-run than you would with other types of accounts.
The Roth IRA (not the Roth 401k or Roth 403b though) also has the benefit of avoiding requiring minimum distributions when you reach age 72. So rather than being forced to remove money from the account, you can leave more of it invested and growing for tax-free use later or to pass on to your heirs, which brings us to the last major benefit…
Those who inherit your Roth IRA get to avoid paying income tax when they take money out of the account. Under the SECURE Act, inheritors are allowed 10 years before they’re required to remove the money from inherited Roth IRAs. So this gives your heirs 10 additional years of untaxed growth on money that remains in the account.
All-in-all the Roth IRA is a pretty sweet deal for those who are able to contribute to them.
An Opening in the Tax Code: What are Backdoor Roth IRA Contributions?
A “Backdoor Roth IRA” is not a separate type of Roth IRA account, though it does sound like it could be. Instead, it refers to the method for which contributions are made. Because high-earners are not able to put money directly into a Roth IRA (through the front door), there are some extra hoops that need to be jumped through for them to get money into a Roth IRA (hence the reference to going through the open back door).
The IRS’s definition of a high earner in 2020 is someone who has an AGI of more than $139,000 ($140,000 for 2021) as a single income tax filer or a couple who makes more than $206,000 ($208,000 for 2021) and files jointly. The max AGI is only $10,000 (not a typo) if married and filing separately. Anyone making less than these amounts can make a Roth IRA contribution (though if you’re within the phaseout ranges, you may only be able to make a partial contribution) and should go that route if planning to contribute for the year. It’s only the people who make more than these income limits who should worry about the added steps needed (below) to get money into a Roth IRA.
How to Make Backdoor Roth IRA Contributions
In order for high-earners to get money into a Roth IRA, there are a few steps you’ll need to take:
- You’ll need both a Traditional IRA account & a Roth IRA account for this. So open one of each type of account, if you don’t already have them.
- Make a non-deductible contribution to the Traditional IRA by the contribution deadline, up to the maximum contribution limit for the year. In 2020, that limit is $6,000 for anyone under 50 years old and $7,000 for those who are 50 or older.
- After a period of time that you feel comfortable with (noting the step doctrine below), convert your non-deductible Traditional IRA contribution to your Roth IRA.
Considerations When Making Backdoor Roth IRA Contributions
Though all of the considerations below are important, pay special attention to the sections on Pro-Rata Rules and Taxation at Conversion if you are considering whether annual Backdoor Roth IRA contributions make sense for you.
Backdoor Roth IRA Legality
It may sound like this strategy is not above-board (for the record, I would never recommend it if it weren’t), but the IRS has officially said they are OK with the Backdoor Roth IRA contribution strategy after a Congressional Conference Report clarified the tax law in 2017: “Although an individual with AGI exceeding certain limits is not permitted to make a contribution directly to a Roth IRA, the individual can make a contribution to a traditional IRA and convert the traditional IRA to a Roth IRA.”
Feel confident that you can proceed with the strategy and stay within the bounds of the tax law.
Pro-Rata Rules
Backdoor Roth IRA contributions can be a powerful planning strategy. However, they don’t make sense for everyone. A Backdoor Roth IRA strategy typically does not make sense for people with large amounts in non-Roth IRA accounts. This is because the IRS looks at two things when you do a Roth conversion (Step 3):
- the amount in your IRA accounts that you’ve already paid taxes on, and
- the total value of ALL of your non-Roth IRA accounts (Traditional IRA, Rollover IRA, SEP IRA, SIMPLE IRA)
The IRS will then require you to pay tax on the proportional share that you haven’t paid taxes on yet. They don’t let you choose which money you’re converting, so unfortunately, you can’t say you’re only converting the non-deductible contribution from Step 2 to avoid the pro-rata tax.
For example, let’s say you have $50,000 in a Rollover IRA and $50,000 in a SEP IRA, for a total of $100,000 in non-Roth IRA money that you have not paid taxes on yet. This year, you’d like to make a maximum Backdoor Roth IRA contribution of $6,000. After you put the money into your Traditional IRA (Step 2), you then have a total of $106,000 in your IRAs and $6,000 that you’ve already paid taxes on. When you convert the $6,000 to the Roth IRA (Step 3), you’ll be able to avoid paying taxes on $6,000/$106,000, or 5.66% of the conversion amount, which means the other 94.34% ($5,660) will be taxable. As you can see, this can lead to paying taxes twice in the same year on a part of the Backdoor Roth IRA contribution you were trying to make.
Because the IRS only looks at specified ”IRA” accounts when looking at the pro-rata rules, one solution might be to roll your IRA accounts into your employer-sponsored 401k, 403b, or another non-IRA retirement plan, if you’re able, thus getting rid of the IRA assets that the IRS will look at when you do the Roth conversion. If you’re not able to roll your IRA(s) into a non-IRA retirement account, you’ll need to weigh the cost/benefit to determine for yourself whether a Backdoor Roth IRA contribution is worth it to you. In most instances, I’d say it’s not worth it, so it’s totally OK if you decide it’s not the best strategy for you either.
Also, it’s important to keep in mind that these pro-rata rules are per person, so if you’re married and can’t make this work for yourself, take a look at whether a Backdoor Roth IRA contribution could work for your spouse. One contribution per family is better than none.
Taxes at Conversion
As alluded to above, you might find yourself paying taxes if you convert money you haven’t yet paid taxes on. Since you do not receive a tax deduction on the contribution from Step 2, I’m not referring to that money. Instead, this usually happens if you have contributions from prior years where you did receive a tax deduction or you have investment gains within the Traditional IRA at the time of conversion.
Since it’s not usually recommended to pull money out of your retirement account to pay for the taxes caused by Roth conversions, these taxes can be particularly painful. In the case of the investment gains, you can minimize these taxes by getting the money into the Roth IRA as soon as possible rather than letting them sit in the Traditional IRA account.
On the other hand, if you have other money within IRA accounts (Traditional IRA, SEP IRA, SIMPLE IRA) that you received a tax deduction for and you have not made a deliberate decision to convert it all to a Roth IRA, you’ll want to really understand the Pro-Rata rules above and how they impact the taxation of Backdoor Roth IRA contributions.
IRA Contribution Deadline
The deadline to make IRA contributions (including those that will eventually make their way into your Roth IRA) and have them count for the current tax year is the tax deadline (usually April 15) for that given tax year. So for 2020, that would mean you have until April 15, 2021 to make the Traditional IRA contribution (Step 2).
Timing of the Conversion
There is no deadline for when you are required to convert your non-deductible Traditional IRA contribution to your Roth IRA (Step 3 above). In fact, you’re not required to do the conversion at all. However, I would typically recommend you do it, and you should do it sooner rather than later to avoid any potential additional income tax consequences from letting the Traditional IRA account grow.
If you’re aware of and concerned about the IRS’s Step Transaction Doctrine (which used to be a consideration when making Backdoor Roth IRA contributions before the IRS officially OKed them in 2018), you need not be any longer.
The Bottom Line: Is it Worth Making a Backdoor Roth IRA Contribution Every Year?
As long as you can avoid the pro-rata rule pitfalls, the Backdoor Roth IRA is one of my favorite tax hacks for high-income earners. Here’s why:
With contributions of $6k per year for only 20 years and a 7% annual growth rate, you could have a $245,973 stockpile of tax-free money to use for your retirement. With 30 years of contributions, the Roth would be worth $566,765, which is roughly equivalent to $871,946 in a Traditional IRA (assuming a 35% total tax rate)!
At the end of the day, you’ll already be paying tax on the money whether you make the contribution or not. So if you’re going to be investing the funds for retirement anyway, you might as well get the money into an account where the growth can accumulate tax-free.