What Is a Backdoor Roth IRA?

But not everyone can contribute to a Roth IRA. According to IRS rules, eligibility to contribute is based on your income and tax-filing status. If your annual income – specifically, your modified adjusted gross income – is above a certain limit, you won’t be able to make contributions directly to a Roth IRA.

This is where the backdoor Roth IRA strategy comes in. With this option, you’d open and fund a Traditional IRA with nondeductible (after-tax) contributions and then convert those funds to a Roth IRA (note: nondeductible contributions are contributions for which you cannot take a tax deduction).

For earners who cannot make direct contributions to a Roth account due to the income caps, this is a technique for contributing to a Roth IRA.

Be aware, however, using this strategy may trigger a taxable event depending on your financial situation. In other words, you may have to pay taxes on some or the full amount you’re converting, so we recommend first consulting a tax advisor.

Important tax considerations

A backdoor Roth IRA comes with a number of tax considerations. You’ll want to speak with a tax professional before using this strategy as part of your tax or retirement planning.

While using this strategy may appear straightforward, the tax calculations can get complicated due to the IRS pro-rata rule for Roth conversions. This is especially true if you have multiple Traditional IRAs or your account(s) contains a mix of deductible and nondeductible contributions.

With the IRS pro-rata rule, the IRS looks across all the Traditional IRAs you own and treats them as one single account (taxable entity) when assessing the taxes owed on your conversion. Generally speaking, any deductible contributions and investment earnings (i.e., funds that were not previously taxed) you’re converting from your Traditional IRA are taxable.

To help figure out the taxable amount of your conversion, you’ll have to determine what percentage of your total Traditional IRA balance consists of deductible contributions versus nondeductible contributions. The percentage of your deductible contributions (out of the total balance across your Traditional IRAs) is then used to help calculate the taxes owed on your conversion.

Here’s a basic example:

• Say you have two Traditional IRAs with a combined balance of $100,000, and 80% of that balance consists of deductible contributions and 20% in nondeductible contributions.
• You plan on converting $5,000 to a Roth IRA via the backdoor strategy.
• Based on the pro-rata rule, 80% of the amount you’re converting ($5,000 x 80% = $4,000) may be subject to income tax.

*The calculations in this example are for illustrative purposes only.

As you can see, the tax calculations can get complicated if you own multiple Traditional IRAs or your account(s) contains a mix of deductible and nondeductible contributions. This is why it may be worthwhile to enlist the help of a professional tax advisor if you’re considering this strategy.

Good to know: The deadline for converting funds in retirements accounts to a Roth IRA is December 31 of the year for which taxes will be owed on the converted funds.

Does this strategy make sense for you?

This strategy may make sense for earners who can’t contribute to a Roth IRA directly due to IRS income caps but want the potential tax benefits that a Roth account has to offer.

That being said, this strategy may not be appropriate for all. It really depends on your financial circumstances. Here are some key considerations to keep in mind:

• A backdoor Roth conversion may come with an unexpected tax bill depending on how much you’re converting.
• Your conversion could also kick you up into a higher tax bracket for the tax year.
• The amount you convert is subject to its own five-year rule, which means you’ll have to wait five years before you can withdraw the converted portion tax-free.
• You cannot recharacterize a backdoor Roth conversion.

Bottom line: Talk to your tax advisor for more information or if you have questions about your situation – they can guide you through the conversion process and potential tax implications. Together, you can then decide whether this strategy is appropriate for you.