What Are the Tax Implications of a Backdoor Roth IRA?

How to take advantage of a Roth IRA when your income makes you ineligible

A person analyzes documents.
•••

Morsa Images / Getty Images

A Roth IRA is a powerful and popular tool for retirement savings. It offers tax advantages such as tax-free growth on your investments and tax-free withdrawals during retirement. But depending on your income, you may not be able to contribute directly to a Roth IRA.

That’s where the backdoor Roth IRA comes in. While not an actual account, this investment strategy can help you move your retirement funds from a pretax to a Roth account. But there are some tax implications to be aware of, including taxes on the converted funds, the pro-rata rule, the five-year rule, and more.

Key Takeaways

  • A backdoor Roth IRA is an investment strategy that involves converting funds from a traditional IRA to a Roth IRA.
  • A backdoor Roth is an excellent option for those who want to take advantage of a Roth IRA, but their income makes them ineligible for direct contributions.
  • There are a few tax implications of a backdoor Roth IRA, including income taxes on your converted funds, the pro-rata rule, and the five-year rule.
  • A backdoor Roth can help some taxpayers reduce their tax burden during retirement, but others might actually pay more in taxes in the long run using a Roth conversion.

What Is a Backdoor Roth IRA?

Despite what it sounds like, a backdoor Roth IRA isn’t actually a type of retirement account. Instead, it’s a strategy investors can use to convert funds from a traditional IRA to a Roth IRA. The use of the word “backdoor” in the title stems from the fact that this strategy is typically used by investors who are ineligible to contribute directly to a Roth IRA because of their income level. With a backdoor Roth IRA, they are circumventing those contribution rules.

A Roth conversion can be done in three ways. First, you can take a distribution from a traditional IRA, then deposit those funds into a Roth IRA. As long as you make the deposit within 60 days of the distribution, it won’t be treated as an early distribution for tax purposes.

The other ways of converting funds to a Roth IRA are done directly through the financial institution where the account is housed. You can either transfer the funds from one trustee to another, directing the new trustee to deposit the money into a Roth IRA instead of a traditional one; or if you’re keeping the funds within the same financial institution, you can simply request it make the transfer.

Keep in mind that because traditional and Roth IRAs have different tax treatments, you’ll have to report any Roth conversion to the IRS. You do this using IRS Form 8606 when you file your federal tax returns.

Who Can Benefit From a Backdoor Roth?

A backdoor Roth can be a valuable tool for someone who wants to take advantage of the tax benefits this type of account offers, but who isn’t eligible to contribute directly to a Roth IRA.

“At higher income levels, a contribution to a Traditional IRA is no longer tax-deductible,” Eric Figueroa, a Certified Financial Planner and the founder of Hesperian Wealth, told The Balance in an email. “At that point, you might as well contribute to a Roth IRA, where your contribution is also not tax-deductible but you'll never owe taxes on the account and its earnings again.”

If you or your spouse aren’t covered by a retirement plan at work, you can deduct your full traditional IRA contribution no matter what your income is. But if you do or your spouse does have access to a workplace retirement plan, there are some limits on traditional IRA deductions.

In 2022, the IRS allows investors with a workplace retirement plan to deduct their full traditional IRA contribution if they earn $68,000 or less for a single filer or $109,000 for a married filer. If your income exceeds that amount, you can take a partial deduction. But once your income exceeds $78,000 for a single filer or $129,000 for a married filer, you can’t deduct any of your contributions.

However, as mentioned, there are also limits on who can contribute to a Roth IRA. The full contribution is only allowed for single filers with income below $129,000 and married filers with income below $204,000. Once your income reaches $144,000 for single filers and $214,000 for married filers, you can’t contribute at all.

“The problem is your high income may eventually restrict you from contributing to a Roth IRA directly,” Figueroa said. “However, as current law stands, you can contribute to a traditional IRA and then convert it into a Roth IRA. It's a legal loophole around the income-based Roth IRA contribution limits.”

Backdoor Roth IRA Tax Implications To Watch For

A backdoor Roth IRA can be an excellent way for taxpayers who may not otherwise be eligible to contribute to a Roth IRA. However, there are a few tax implications to be aware of.

Previously Deductible Contributions Will Be Taxed

Contributions to a traditional IRA are tax-deductible, while those to a Roth IRA aren’t. As a result, you may end up converting funds that were previously deducted from their taxable income to a Roth IRA. While this is allowed, it means you’ll have to go back and pay taxes on the converted funds.

Suppose last year you contributed $6,000 to a traditional IRA and deducted that amount from your taxable income. If this year you were to convert that money to a Roth IRA, it would be considered taxable income and you would pay income taxes on it at your ordinary tax rate.

“Be aware, when you convert your traditional IRA to a Roth IRA, you owe taxes on any amount that hasn't already been taxed,” Figueroa said. “To maintain your account value, you'll have to pay those taxes from outside the IRA. Make sure you have the funds to do so!”

The good news is that if you have already paid taxes on the funds in the traditional IRA, then you won’t have to worry about the income tax implications. However, if the value of your account has grown from your investment earnings and you convert that money as well, you’ll have to pay income taxes on any increase from your original contribution.

Plan for the Pro-Rata Rule

If you've made both deductible and nondeductible contributions to your traditional IRA, the tax implications of your backdoor Roth conversion may be slightly more complicated.

“The tax calculation can get complicated if a portion of your IRA assets has already been taxed and the rest has not been taxed,” Figueroa said. “You can't designate just the portion that's already been taxed for your conversion to avoid a tax payment. The IRS follows the pro-rata rule, which requires that IRA assets be converted proportionally.”

Suppose you had $5,000 in your traditional IRA, $2,500 of which was contributed with pretax dollars and the other $2,500 of which was contributed with after-tax dollars. In that case, you’ll pay income taxes on half of your Roth conversion.

However, as Figueroa said, you can’t choose which dollars to convert. If you’re converting only a portion of your traditional IRA funds, the proportion of your conversion that’s taxed will be proportional to the percentage of your entire IRA that was deducted from your taxable income.

Your Long-Term Tax Rate Could Be Higher

Many financial experts recommend the Roth IRA for its incredible tax advantages. But depending on your situation, you might actually end up paying more income taxes in the long run with a backdoor Roth than if you had simply left the money in your traditional IRA and paid income taxes on it during retirement.

The benefit of a traditional over a Roth IRA all comes down to your tax rate. If your tax rate ends up being lower during retirement than it is today, then you would be better off not converting pretax retirement dollars to a Roth IRA.

However, this only applies to investors who are eligible to deduct their traditional IRA contributions. If you aren’t eligible for the traditional IRA deduction, then the tax advantage of the backdoor Roth far exceeds that of a nondeductible traditional IRA.

Watch Out for the Five-Year Rule

Roth IRAs have what’s known as a “five-year rule,” where you must wait at least five years after your first contribution to the account before you can make any tax-free and penalty-free withdrawals. Because you’ve already paid income taxes on your contributions, you can withdraw those (but not your investment earnings) penalty-free after those five years have passed.

With a backdoor Roth, the five-year rule works a bit differently. Instead of being able to withdraw funds five years after first contributing to the account, you can only withdraw funds that have been in the account for at least five years. Suppose you already had a Roth IRA that you’d been contributing to for 10 years. If you convert $10,000 from your traditional IRA into your Roth IRA, you must wait a full five years before you can withdraw that $10,000.

If you take any Roth IRA withdrawals earlier than the applicable five-year rule allows, you’ll be subject to a 10% early distribution penalty.

Is a Backdoor Roth a Good Idea?

The Roth IRA is one of the most popular and highly-recommended retirement accounts available. Once you’ve paid taxes on your contributions, you’ll never pay taxes on the funds in your account again. For many investors, choosing a Roth over a traditional IRA is a no-brainer.

But many of the people who take advantage of a backdoor Roth IRA do so because their high income prevents them from directly contributing to this type of account. Also, because converting your retirement funds to a Roth account means paying taxes on them, it may not make sense for people who already have a high tax burden.

So how can you decide if a backdoor Roth IRA is right for you? “For taxpayers who don't qualify for further tax-deductible saving but want to save more, a backdoor Roth is a great option if they have the income to contribute,” Figueroa said.

But according to Figueroa, it’s not quite as cut and dry for high-income earners who haven’t maxed out their tax-deductible investment accounts, such as their 401(k) plan.

“A backdoor Roth is better than an after-tax traditional IRA contribution, but it's not guaranteed to be better than a tax-deductible contribution to an employer-provided retirement plan when your tax rate is likely to be lower in retirement, not higher,” Figueroa said.

Rather than simply looking at your tax situation today, Figueroa said the best way to determine whether a backdoor Roth IRA is right for you is to project your tax rates out over your entire lifetime.

If you aren’t sure what to make of that information, there are online Roth calculators that allow you to plug in your tax rate today, as well as your estimated tax rate in the future. Using that information, the calculator will show your projected tax burden based on both scenarios.

Frequently Asked Questions (FAQs)

How do you file taxes for a backdoor Roth IRA?

To file taxes for your backdoor Roth IRA, fill out and file IRS Form 8606 when you file your annual tax return. This form is used for all deductible IRA contributions, IRA distributions, and IRA conversions.

When do you pay taxes on a Roth IRA?

Roth IRA contributions are done with after-tax funds, meaning the income taxes were likely withheld from your paycheck. But if you’re completing a backdoor Roth IRA, you’ll pay income taxes on the funds at the time of the conversion.

Want to read more content like this? Sign up for The Balance’s newsletter for daily insights, analysis, and financial tips, all delivered straight to your inbox every morning!

Article Sources