Backdoor Roth IRA
The backdoor Roth IRA is a loophole to fund your retirement account. It is not an investment strategy. It’s a loophole in the tax law that allows you to circumvent traditional IRA contribution limits.
Backdoor Roth IRA can be used for anyone with earned income, but high earners primarily use it.
What Is a Backdoor Roth IRA?
A Backdoor Roth IRA is an indirect method for funding an individual’s retirement account. It is a backdoor way to contribute money into your Roth IRA without exceeding the income limits.
When is the backdoor Roth IRA possible?
The backdoor Roth IRA is possible whenever an individual has already contributed to their 401(k) or other employer-sponsored plans for that year.
Steps to Set Up Backdoor Roth IRA
Here are the steps to establish your backdoor Roth IRA:
Step 1. Contribute to your traditional IRA for the year.
If you contribute to your traditional IRA for the year, it will count towards your total allowable contributions. This means that if you max out on all of your other options before making backdoor Roth IRA contributions, this step alone is enough to account for backdoor Roth IRA opportunities in that year.
Step 2. Convert it into a Roth IRA
Once you have contributed to your traditional IRA, convert the account into a Roth IRA. This allows you to take advantage of backdoor Roth IRA opportunities without paying taxes on your contributions (which is how backdoor Roth IRAs are best used).
Step 3. Repeat for future backdoor Roth IRA opportunities
After converting your traditional IRA to a Roth, you can repeat the process in succeeding years. Just keep in mind that backdoor Roth IRA contributions do count towards your annual IRA contribution limit.
Why Should You Backdoor Your Retirement Account?
By backdooring your retirement account, you can take advantage of the tax benefits associated with a Roth IRA. These tax benefits include:
- no required minimum distributions (RMDs) for Roth IRAs during the lifetime of the original owner and their spouse
- money in a Roth is allowed to grow completely income-tax free
- backdoor Roth IRA contributions are treated as regular Roth IRA contributions, which means they can be withdrawn tax and penalty-free at any time
Pros & Cons of Backdoor Roth IRA
The backdoor Roth IRA is a popular strategy for high earners. It comes with many benefits:
- backdoor Roth IRA contributions are allowed to grow tax-free
- backdoor Roth IRAs allow individuals who have already maxed out their other options the opportunity to contribute even more money into a retirement account every year
- the ability to withdraw funds without penalties or taxes at any time can be useful if you anticipate needing extra cash in your advanced years (i.e., unexpected medical bills)
The backdoor Roth IRA has its disadvantages as well:
- backdoor Roth IRA opportunities rely on withdrawals from employer-sponsored plans, which may leave you exposed to early withdrawal penalties and income taxes
- backdoor Roth IRA opportunities are limited to individuals who have already maxed out their other retirement options
- backdoor Roth IRA contributions count towards your annual contribution limits for other tax-advantaged accounts, so you may have to give up certain investments to make backdoor Roth IRA contributions
Sample Tax Scenario and Considerations
Here is an example of backdoor Roth IRA contribution and how it will be taxed:
Joe makes $200,000 a year. He has made the maximum allowable contributions to his 401(k) plan for that year.
He also maxed out on backdoor Roth IRA opportunities in previous years. This leaves no other tax-advantaged investment options available to him at this time.
Joe decides he wants to take advantage of Backdoor Roth IRA opportunities, so he takes money from his traditional savings account and converts it into a Roth IRA.
He repeats the process next year when he finds himself with limited tax-advantaged investing once again options.
In doing this, however, there are some things to consider.
First is Joe will have to pay taxes on backdoor Roth IRA conversions. Backdoor Roth ira contributions are treated as regular Roth IRA contributions, which means they can be withdrawn tax and penalty-free at any time.
Since the money was converted from a traditional savings account, it is not subject to early withdrawal penalties. However, it may still be taxed upon withdrawal, depending on how much income Joe has reported in that given year.
If he withdraws before his filing deadline, then anything extra will get taxed like normal income, while withdrawals made after April 15 would only be taxable up until that point in time.
When doing backdoor Roth IRAs, make sure you do your research and plan accordingly so you don’t lose out on money or pay penalties that could have been avoided.
If backdoor Roth IRA opportunities are available to you and you feel suitable for your financial goals, consider an expert’s advice before doing anything.
The backdoor Roth IRA has many advantages but also some disadvantages as well. Backdoor Roth IRAs can be beneficial if you anticipate needing extra cash in your advanced years (i.e., unexpected medical bills).
However, backdoor Roth IRA contributions count towards your annual contribution limits of other tax-advantaged accounts, which may leave certain investments out of the question until next year’s returns roll around again.
Consult a professional with any questions or concerns about backdoor Roth IRAs so that they don’t end up costing more money than expected due to mistakes made.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.