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If you want to open a Roth IRA and make too much money to do so, don’t fret. While high-income individuals are shut out from contributing directly to a Roth IRA, they can still gain entry to this popular retirement savings vehicle by employing a strategy called a “backdoor” Roth IRA.
However, this strategy may not exist for long, since Congress has debated whether to eliminate it as a way to fund new spending plans.
Here’s what you need to know about the backdoor Roth IRA and how to avoid a trap that might cost you thousands in extra taxes.
How Roth IRAs work
A Roth IRA is similar to a traditional individual retirement account, but you fund it with money that’s already been taxed — meaning there’s no upfront tax break as there is with the traditional IRA. In 2022, you can contribute up to $6,000 to your IRA, or $7,000 if you are age 50 or older.
The big benefit of a Roth IRA is that your withdrawals are tax-free in retirement. What’s more, Roth IRAs are not subject to required minimum distributions, so you can let the money compound for longer.
The hitch: To qualify for a full Roth contribution in 2022, you cannot make more than $204,000 if married and filing jointly, while those with incomes of up to $214,000 can make a reduced contribution. If you’re single, you’ll need to make less than $129,000 to make a full contribution, while those making up to $144,000 can make a partial contribution.
This limit disadvantages high-earners when it comes to reaping the tax benefits of these retirement accounts. The solution to this dilemma is the backdoor IRA.
How to set up a backdoor Roth IRA
With a backdoor Roth IRA, you deposit money in a non-deductible traditional IRA and then convert that IRA into a Roth IRA. A backdoor Roth IRA can be relatively easy to set up, but you’ll want to carefully consider the potential costs and tax liabilities of doing so (more below). Here are the key steps:
1. Make a contribution to a non-deductible traditional IRA
First, you’ll need to make a contribution into a non-deductible traditional IRA. A non-deductible traditional IRA is one where you contribute with after-tax money. You don’t contribute with pre-tax income and enjoy a tax break on your current taxes.
2. Open a Roth IRA
Next, you’ll need to have a Roth IRA account opened to transfer the funds from your non-deductible traditional IRA.
If you already have an existing Roth IRA at your current broker or another one, you can use that account or open a new one.
3. Initiate the conversion
Once you’ve opened a Roth IRA, you can contact the broker and begin the conversion process. Each broker’s process may be a little different, but generally you’ll need to fill out a form authorizing the conversion of the traditional IRA and then listing which assets you want to move.
4. Move the funds
Submit the form to your broker, and it will begin the conversion process. Your broker may charge you for closing your IRA account, and may charge an additional fee if you’re moving assets in kind, that is, if you’re moving stock from one account to another rather than just cash.
The conversion process may take a couple of weeks, though many brokers can accomplish it in a few days.
Potential costs of a backdoor Roth IRA
While income caps keep some individuals from contributing to a Roth, there are zero income restrictions on converting a traditional IRA to a Roth IRA. That means high-income investors can make nondeductible IRA contributions and then convert them to a Roth. A nondeductible contribution is one to a traditional IRA that does not come from pre-tax income.
This process can be simple but may not be, if you have money in other traditional IRAs that you’re not converting.
First, the good news. If you have only nondeductible contributions in a traditional IRA (or several), then you can convert a nondeductible IRA into a Roth IRA with no tax consequences.
Now, the bad news. If you’ve made deductible contributions to a traditional IRA, you’ll owe taxes if you convert any nondeductible amounts into a Roth IRA. To figure out what you’ll owe, you must abide by the IRS’s pro rata rule, which forces you to consider your IRA assets as a whole.
To do so, you must figure the ratio of IRA funds that have never been taxed (in other words, deductible IRA contributions and earnings) to the total assets in all of your IRAs. That portion of any rollover amount becomes subject to tax at your ordinary tax rate.
For example, let’s say you’ve previously made $94,000 in pre-tax contributions to a traditional IRA and make a non-deductible IRA contribution of $6,000 this year with the intention of converting to a Roth IRA. In this case, 94 percent of your total $100,000 in IRA assets has not yet been taxed. That means that 94 percent of your $6,000 contribution, or $5,640, would be taxable upon conversion. If you opted to convert your entire $100,000, you’d owe taxes on $94,000.
This situation often stops many would-be converters cold. It can be particularly tricky if you roll over a traditional 401(k) plan, because you may be moving pre-tax contributions into a traditional IRA. Even if you have a Roth 401(k) with after-tax contributions, any employer match is considered a pre-tax amount, and so would be rolled over into a traditional IRA plan.
If this situation applies to you, don’t despair. You can work around the pro rata rule, too — with a reverse rollover.
Use a reverse rollover to avoid the pro rata rule
If your employer’s 401(k) plan allows you to roll IRA money into it, you can move your deductible IRA contributions and pre-tax earnings into the 401(k). This is a good move if your employer’s plan offers solid, low-cost investment options.
Then you can convert any remaining non-deductible contributions you‘ve made to a traditional IRA into a Roth IRA. In this case, you’d owe no taxes on the conversion and would be able to take advantage of the Roth IRA’s benefits.
Andrew Westlin, CFP, a financial planner at Betterment, says this can be a great strategy — but it’s only effective if the plan’s sponsor allows rollovers and if the individual has been keeping tabs on their tax basis for any accounts.
“You, as the investor, need to know how much non-deductible basis you have in your IRAs so we can accurately determine how much can be converted and how much needs to be rolled in,” Westlin says.
Why do a backdoor Roth IRA conversion?
Traditional IRAs and Roth IRAs provide attractive tax benefits to incentivize saving for retirement, but those benefits are only available to individuals who don’t earn too much. Those above the income threshold can’t take advantage of a Roth IRA, meaning they can’t grow their retirement savings completely tax-free..
So a backdoor Roth IRA conversion allows high-income earners to get those tax benefits. But the Roth IRA offers some other great benefits, including:
No required minimum distributions
In a 401(k) and traditional IRA, you have to take a required minimum distribution from the fund once you hit a maximum age (typically 72 now). Not so with a Roth IRA. By not having to withdraw funds, you can let that money continue growing. This benefit can help someone who has multiple sources of income in retirement and can put off tapping the Roth IRA.
You can transfer the wealth tax-free
Money in a Roth IRA can be turned over to heirs tax-free, as long as you owned it for more than five years. Keep in mind, however, that the heirs will have to abide by the restrictions on inherited IRAs, but may have some time to grow the money inside the IRA.
Be careful setting up a backdoor Roth IRA
You can get started with the backdoor conversion by contacting your bank or brokerage, but you want to be careful. If you don’t follow these rules closely, you could get hit with a major tax bill.
Megan Gorman, a founding partner of Chequers Financial Management, says consumers should contact a tax professional first before attempting a backdoor Roth on their own.
“It’s a great idea, but the aggregation rules and the rules regarding nondeductible versus deductible are complex, so it’s hard for investors who are do-it-yourself-investors to get it right,” Gorman says. “They are fraught with risk — if you do it wrong, you can hurt yourself tax-wise. Tax professionals are the ones who can really give this advice because they see the whole picture.”
For example, you might be hit with taxes if your contribution to a traditional IRA generates earnings before you’re able to convert it into a Roth IRA. Those earnings are subject to tax.
So this is a great time to call in an expert financial advisor to help with your situation.
The backdoor Roth IRA can be a great idea for those whose income shuts them out of opening a Roth IRA the regular way. But you’ll want to make sure you understand the process fully so that you avoid any nasty tax surprises, and that’s why it could be helpful to hire an expert to help you navigate the process effectively.
Note: Bankrate’s Brian Baker contributed to an update of this story.
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