Backdoor Roth IRAs

What is a backdoor Roth IRA?

Contributing to retirement accounts like 401(k)s and IRAs is the most common way to ensure you have the income you need after you retire. There are lots of rules around each that can get confusing quickly, but for this article, we’re really only concerned with one: Usually, people who surpass certain income limits can contribute to traditional IRAs, but not to Roth IRAs.  

A backdoor Roth IRA, which involves converting a traditional IRA into a Roth IRA, gets around that rule. It is legal and even encouraged by the IRS as long as tax laws are followed.

IRA basics: Roth vs. traditional

Both Roth and traditional IRAs operate under many of the same rules, including how much you contribute each year and when you can begin accessing the funds. There are a few minor differences between the two, but the main one is when they are taxed.  

The contributions of a traditional IRA are tax deductible in the year you make them. You then pay normal income taxes when you withdraw funds from the account in retirement. This is generally beneficial, because it allows the account to grow faster, and typically your income in retirement is less than in your prime earning years, meaning you’ll often be in a lower tax bracket.

In contrast, contributions to a Roth IRA are made after they’ve already been taxed. They are not tax deductible. However, when you withdraw the funds in retirement, they are tax free. Learn more about IRA basics here.

Is a backdoor Roth IRA a tax dodge?

No. This strategy might in fact incur more taxes than normal when you set it up. Simply put, when you convert tax-deducted funds from a 401(k) or traditional IRA to a Roth IRA, you will owe taxes on that amount and whatever has been earned prior to the conversion. If the account being converted is sizable, this can lead to a considerable tax bill in the year of the conversion. However, that is in exchange for the tax benefits you’ll realize later. As always, you should consult a tax professional before making decisions like this.

Backdoor Roth IRA income limits

The backdoor maneuver gives you a legal way to sidestep some of the income and yearly contribution limits that are usually associated with Roth IRAs. Still, it’s important to understand these limits, as they will still apply in the future after a conversion.  

Roth IRA income limits

For 2024, once you have a modified adjusted gross income (MAGI) over $161,000 as an individual, or $240,000 filing jointly, you are not allowed to contribute to a Roth IRA. If your income is under this amount, you can fund a Roth IRA normally, and should not have the need for a backdoor Roth IRA. Read more about Roth IRA limits at irs.gov.

Roth IRA contribution limits

For contribution limits, the number you can contribute applies to both traditional and Roth IRAs together. You can’t contribute the max limit to both. For 2024, that limit is $7,000. If you are over age 50, you can contribute a little more, up to $8,000. These limits only apply to new contributions, so IRA rollovers and conversions can exceed these numbers.

Pros and cons of a backdoor Roth IRA

Whether you decide to use a backdoor strategy or not will depend on your retirement goals and should be discussed with a financial professional as part of a larger retirement or wealth plan.

Benefits of a backdoor Roth IRA

The benefits of creating a backdoor Roth IRA are tied to your overall retirement and wealth strategy. Taken by itself, a backdoor Roth IRA may not offer much, but as part of a larger plan, it can allow higher earners to gain specific benefits:

• Gets around the contribution limit
  As discussed previously, the main benefit is the ability for high-income families to have a Roth IRA. Usually, they would not be able to do so.
• No required minimum distributions (RMDs)
  With traditional IRAs, once you reach age 73 you must start making withdrawals. One big advantage of Roth IRAs is that you are not required to do so, which means you can take only what you need, when you need it. You can also leave the accumulated funds to your heirs.
• Distributions in retirement are tax free
  As with all Roth IRAs, the withdrawals made are tax free after age 59½. That can be beneficial if tax rates are higher, your income is higher, or you simply want to enjoy the ease of tax-free income. 

Downsides of a backdoor Roth IRA

Backdoor Roth IRAs are not right for everyone. If you do not meet the income limits and can contribute to a Roth IRA normally, there is very little reason for you to explore this option. However, there are other instances where they should probably be avoided. Here are some things to watch out for:

• Paying the immediate taxes
  You generally do not want to use your actual IRA funds to pay the taxes due during a backdoor Roth IRA conversion. This can slow down the growth of your account by taking a large chunk out of it, and you may even owe additional taxes (up to 10%) if it counts as an early withdrawal. 
• Waiting for the money
  The Roth five-year rule does not allow you to withdraw tax-free earnings before five years. So, if you’re already near retirement and want to access the funds before that, a backdoor Roth IRA is likely not a good option for you. 
• Staying aware of your tax brackets and other tax considerations
  Before you make any decision,  you’ll want to work with a tax professional and take care that it does not push you into a higher tax bracket, which may result in your owing more on your entire income. Instead, you can convert an amount that keeps you under the tax-bracket limit and convert more in the future.
  
  If you employ the back door Roth IRA strategy and have other traditional IRAs that have pre-tax money in them, you can’t just convert the after-tax contributions and avoid tax consequences on the conversion. Instead, a proportionate amount of the pre-tax funds will be deemed converted and will be taxable. This is known as the pro-rata rule. All of your IRAs, traditional or Roth, are considered for this calculation.

How do you create a backdoor Roth IRA?

The first step is having a financial professional you can work with and trust. They should be able to find the most efficient and beneficial way to structure all of your retirement accounts to meet your goals. If, with their help, you decide a backdoor Roth IRA is right for you, here are the ways in which you can create one:

Roll over traditional IRA funds to a Roth IRA

You can set up a traditional IRA and fund it up to the yearly limit ($7,000 in 2024), then roll it over into a Roth IRA. Or you can roll over as much as you want from an existing older traditional IRA. There are specific rules on how to do this—and remember that you will owe taxes on the amount rolled over. Use this option if you want to keep the traditional IRA account active.

Convert a traditional IRA into a Roth IRA

Alternately, you can functionally close a traditional IRA and turn the entire account into a Roth IRA. This can help keep your retirement accounts easier to manage. Otherwise, it functions much in the same way as a rollover, defined above.

Convert a 401(k) account to a Roth IRA

Some employer 401(k) accounts allow for Roth conversions. If this is an option, you can make a potentially larger transfer into a Roth IRA. Again, taxes will still be owed, so make sure you consult a tax professional and have a plan to account for the large tax implications in the year of the conversion.  

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This article is for your general informational purposes only. Neither New York Life Insurance Company, nor its agents, provides tax, legal, or accounting advice. Please consult your own tax, legal, or accounting professional before making any decisions.