Backdoor Roth IRA

LAST REVIEWED May 01 2020 8 MIN READ

By The Human Interest Team

Roth IRAs offer many tax-saving benefits, but higher-income earners often miss out on these advantages. Backdoor Roth IRAs provide an IRS-approved way for individuals of all income levels to contribute to a Roth IRA while saving for retirement. Learn more about what a backdoor Roth is, the advantages and tax implications that come with it, and how to set it up following the IRS rules. 

What Is a Backdoor Roth IRA?

A backdoor Roth IRA isn't an official kind of retirement account. Instead, it's the informal name given to a complicated, IRS-approved way for higher-income individuals to fund a Roth even when their income is more than the maximum amount allowed by the IRS for traditional Roth contributions. If you can't directly contribute to a Roth IRA, this tax loophole will enable you to contribute indirectly, and you should take advantage of it if you qualify. Brokerage firms offering IRA accounts can help you create a strategy for converting traditional IRAs into Roth IRAs. 

Tax Implications of a Backdoor Roth IRA

The IRS sets annual Modified Adjusted Gross Income (MAGI) limits for contributing to Roth IRAs. If your annual MAGI is higher than these limits, you can't contribute to a Roth IRA. Backdoor Roth IRAs allow high-income earners to avoid these limits as they don't apply to backdoor conversions. Examples of MAGI limits are: 

  • $139,000 ($137,000 for 2019) for single individuals 

  • $206,000 ($203,000 for 2019) for married individuals filing jointly or qualifying widowers and widows

Advantages of a Backdoor Roth IRA

Backdoor Roth IRAs can provide significant tax savings for participants in the long run since unlike traditional IRAs, Roth IRA distributions aren't taxable. The main advantage of backdoor Roth IRAs is you pay taxes on your contributions when you make them, meaning everything after is tax-free. This is especially beneficial if you anticipate being in a higher tax bracket later in life. 

There are also no Required Minimum Distributions (RMDs) with Roth IRAs. This means the money in a Roth IRA can grow tax-free for as long as you're alive. You can take out as little or as much as you like, or leave it all for your heirs. 

How to Set up a Backdoor Roth IRA

Single taxpayers having MAGIs of more than $124,000 will see lower contribution limits for Roth IRAs in 2020. Those with a MAGI more than $139,000 will no longer be able to contribute at all. Married taxpayers are at even more of a disadvantage as single limits don't double. Instead, MAGI phase-out levels for married taxpayers start at $196,000 and terminate completely at $206,000, approximately $98,000 to $103,000 for each spouse. 

Traditional IRAs, however, don't prevent or limit individuals earning higher incomes from making contributions. Backdoor Roth IRAs take advantage of this fact with these simple steps. 

  1. Contribute to a traditional IRA

    - for 2020, you can

    . Working spouses can also add $6,000 for a nonworking or lower-income spouse as long as their combined contributions of up to $12,000 aren't more than their total income. 

  2. Immediately convert the traditional IRA to a Roth IRA

    - it's essential to do this step right away, before money in the traditional IRA can result in any earnings. If any gains are made, taxes must be paid on those earnings when the conversion is done. Any traditional IRA earnings will also count as excess contributions, which will need to be corrected when the conversion is done. Doing this step immediately prevents this from happening. 

  3. Repeat this process as often as you need

    - take advantage of a backdoor Roth IRA each year you're unable to contribute to a Roth IRA by regular means.

Follow the IRS Rules

The most important thing to remember when setting up a backdoor Roth IRA is to follow the rules set by the Internal Revenue Service (IRS). 

  1. For individuals already making tax-deductible contributions to a traditional IRA, make sure you're following the pro-rata rule. The best way to deal with this rule is having a zero balance in all

  2. For individuals younger than 59 1/2 years old, don't remove funds you converted to your Roth IRA for a minimum of five years. Removing money sooner will result in paying a 10% penalty unless you're able to qualify for a limited exception. 

  3. Don't let contributed funds fall back into your hands during the conversion from a traditional IRA to a Roth IRA as it can result in unexpected taxes. Doing a trustee-to-trustee transfer or a same trustee transfer can prevent this from happening.

  4. Make sure you complete the

    correctly each year. This form tracks your annual nondeductible contributions and calculates nontaxable and taxable IRA contributions. 

  5. Conversions need to happen one of the following ways:

    A) a rollover where you receive the funds from your traditional IRA and deposit them in the Roth IRA within 60 days,

    B) when dealing with the same financial institution for both accounts a "same trustee transfer" moves funds from your traditional IRA to your Roth IRA, or

    C) when dealing with two financial institutions, a "trustee-to-trustee transfer" where one financial institution sends funds to another.

Is There a Solution to the Backdoor Roth IRA Pro-Rata Problem?

Solving the pro-rata problem when your employer-sponsored plan doesn't accept rollovers is a little more complicated.

  1.  Establish a business and get a tax ID number for it. 

  2.  Create a solo 401(k) using an investment firm that will allow a direct rollover from an existing traditional IRA. 

  3.  Roll funds over from your existing tax-deferred IRA into the new solo 401(k) plan. 

  4.  Establish a traditional IRA. 

  5.  Fund the traditional IRA with your nondeductible contribution. 

  6.  Establish a new Roth IRA or access an existing one. 

  7.  Immediately transfer funds from the traditional IRA to the Roth IRA.

 In this case, it's essential to consult with a tax professional to make sure everything is done correctly. 

Backdoor Roth IRAs are an excellent way for higher-income earners to benefit from the tax advantages of a Roth IRA. Talk with one of our retirement savings experts today to learn how we can help.

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