When You Should Consider a Backdoor Roth IRA

How to Determine Whether This Workaround Is Right for You

Couple reviewing documents with financial planner for a backdoor Roth IRA

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An individual retirement account can be a useful retirement savings tool to supplement your 401(k) or a similar employer-sponsored plan. A Roth IRA affords the opportunity to make qualified withdrawals tax-free in retirement, which can work in your favor if you're in a higher tax bracket. 

Key Takeaways

  • A backdoor Roth IRA involves converting traditional IRA contributions to a Roth IRA. 
  • You will have to pay taxes when you convert a traditional IRA to a Roth. 
  • You may be able to minimize your tax liability by rolling the deductible portion of your traditional IRA into a 401(k) (if that’s allowed). 
  • You can’t withdraw converted funds out of a Roth IRA for at least five years without incurring a penalty.

Who Can Benefit From a Roth IRA

Not everyone can contribute to a Roth IRA. The Internal Revenue Service bases eligibility on your modified adjusted gross income (MAGI) and tax filing status. To make the maximum contribution in 2022, your MAGI must be less than $129,000 if you are a single filer (up from $125,000 in 2021) and less than $204,000 if you are a married couple filing jointly (up from $198,000 in 2021). 

There is, however, a workaround to the income limits. A backdoor IRA offers high earners a chance to enjoy the tax benefits of a Roth, but it may not be right for every investor. 

You can make a reduced contribution (below the maximum) to your Roth IRA if your MAGI is less than $144,000 for a single filer or less than $214,000 for a married couple filing jointly in 2022 (up from $140,000 and $208,000, respectively, in 2021).

How a Backdoor Roth IRA Works

A backdoor Roth IRA involves converting traditional IRA contributions to a Roth IRA. You can use an existing traditional IRA, or open a new account specifically for the conversion. Once you've converted from traditional to Roth assets, you'd be able to enjoy the tax-free withdrawal status of that account. You do, however, have to be aware of any tax liability you might incur as a result of the conversion. 

Tax Liability When Converting to a Roth IRA

Traditional IRAs are funded with pre-tax dollars. Depending on your income, these contributions may be deductible or non-deductible. So why is that important when you're converting to a Roth? 

The IRS doesn't allow you to dodge your tax liability. Typically, you'd pay taxes on these funds when you withdraw them in retirement, at your ordinary income tax rate. If you're converting a traditional IRA that's composed of deductible contributions, you'd have to pay the tax due on those contributions and their earnings at the time of the conversion. 

But what if you're converting nondeductible contributions? That's when things can get a little tricky. If your traditional IRA includes only nondeductible contributions, you'd pay taxes only on any amount above your tax basis. If you have traditional IRAs that include both deductible and nondeductible contributions, however, the IRS will calculate any taxes due on the conversion on a pro-rata basis, using the value of all your IRAs. 

That means if you have $300,000 in traditional assets and contribute the maximum $6,000 to a nondeductible IRA, you couldn't just transfer the nondeductible portion, even if it's in a separate account. You'd have to treat that $6,000 as partial conversion of your total IRA assets for tax purposes. 

If you are age 50 are older, the maximum annual contribution to a Roth IRA is $7,000 for both 2022 and 2021.

Minimize Your Conversion Tax Liability With a 401K

If you're in a higher tax bracket and you're converting a significant amount of traditional IRA funds, the result could be a large tax bill in the year you convert. Fortunately, there is a way to minimize some of the tax liability. 

For tax purposes, the IRS doesn't include 401(k)s under the aggregation guidelines. If you have a mix of both deductible and nondeductible traditional IRA assets, you could roll the deductible portion into your workplace retirement plan if that's allowed. That would leave you free to convert the nondeductible portion of your IRA to a Roth without triggering the pro-rata tax rule. 

Some employers may offer either a Roth 401(k) or 403(b) that is funded with after-tax dollars and grows tax-exempt.

Converting Traditional IRA Assets With a Backdoor Roth

A backdoor Roth IRA can yield some important tax benefits, and it's important to think it through carefully. For example, what tax bracket do you expect to be in when you retire? If you anticipate being in a higher bracket than you are now, the tax savings you could realize through Roth IRA withdrawals may outweigh any tax liability you incur now as a result of the conversion. On the other hand, if you've accumulated a substantial amount in a traditional IRA, converting could be costly. 

Remember also that you can't withdraw converted funds out of a Roth IRA for at least five years without incurring a penalty. The payment must also occur on or after the date you reach age 59 1/2 or older. If you tap the funds before then, you'd owe a 10% early withdrawal penalty, unless you qualify for an exception. It's important to understand your timeline until you think you'll need those funds. 

If you're not planning to tap IRA assets for some time, a backdoor Roth offers yet another benefit. With traditional IRAs, you're required to begin taking minimum distributions—the amount is based on your life expectancy—beginning in April of the year after which you turn 72. Roth IRAs have no required minimum distributions, meaning you can leave the money to grow as long as you like. That, paired with the ability to make those withdrawals without tax, could tip the scales in favor of converting traditional IRA assets.