What Is a Backdoor Roth IRA?

Contributing to a Roth IRA each year is a common and effective way to plan for retirement. However, income limits may prevent you from doing so if you earn too much. For this reason, many turn to the backdoor IRA strategy, which allows a person to make nondeductible contributions despite their earnings.

This article will outline how the backdoor Roth IRA strategy works, including how to set one up. We’ll also list the pros and cons of using this contribution method and explore whether or not you should use it.

How a Backdoor Roth IRA Works

The backdoor IRA is a method to contribute money to a Roth IRA despite already being over the typical income limit, which sits at $240,000 for married couples and $161,000 for individuals. It involves making nondeductible contributions to a traditional IRA and then converting those funds into a Roth account, hence the “backdoor” label. By doing so, you’re able to reap the benefits of withdrawing your earnings tax-free once you retire.

The reason why such a strategy works is because the U.S. Internal Revenue Service (IRS) places no limit on the amount one can roll over into a Roth IRA, even despite typical contribution income limits. This enables you to convert as much as you’d like from a traditional IRA, provided the original contributions were nondeductible and after-tax.

Possible Discontinuation

Currently, the backdoor IRA method is within the boundaries of the law. However, it’s an approach that has been scrutinized, such as in this essay from Yale Law & Policy Review, which asserts that the strategy is a departure from “measuring income accurately and allocating tax burdens based on income and ability to pay.” Despite the criticism, it remains legal after avoiding a potential elimination proposed by members of the U.S. House of Representatives in the Inflation Reduction Act of 2022.

Tax Considerations

There are, however, some important tax implications to consider with the backdoor Roth IRA strategy. Adam Cornwell, CFP^®, CFA, a financial advisor and partner at North Ridge Wealth Advisors, explains that it’s imperative to pay attention to the pro-rata rule, saying, “You can’t just convert the non-deductible contribution; you must convert a proportional amount of any pre-tax and after-tax money held in any traditional IRAs.” The five-year rule is also crucial, where “converted funds must remain in the Roth IRA for at least five years” to avoid any penalties, he continues.

Cornwell also identifies conversion taxes as a factor to keep in mind. “Any pre-tax contributions and earnings converted are considered taxable income, which could push you into a higher tax bracket,” he says. When you take on a Roth conversion, it will likely raise your tax bracket for that year. Therefore, it’s crucial to carefully decide whether the backdoor IRA is worth the tax hit at this time in your life.

One other consideration to make is that, with nondeductible contributions, you don’t get to benefit in the immediate future. According to Sallie Mullins Thompson, CPA/PFS, CFP^®, CDFA, there’s “[no] tax deduction at contribution time.” This may cause you to pay additional taxes while you’re a high earner. It’ll be up to you, with the help of a financial advisor, to weigh the costs and benefits of contributing on a Roth vs. taxable basis.

Pros and Cons of Using a Backdoor Contribution

The backdoor IRA method is a useful way to save for retirement on a Roth basis despite being a high earner. However, there are disadvantages that you should weigh before jumping into the process. This includes a time investment, potential tax implications, and overall complexity.

With the backdoor contribution, you can “bypass income restrictions” and realize “[t]ax-free growth and withdrawals” upon retirement, says Cornwell. You’ll also be able to avoid required minimum distributions (RMDs), which currently start at age 73.

On the other hand, the backdoor Roth IRA is a complex process in which it’s very easy to make mistakes. For example, “if you have other traditional IRAs,” you may be subject to “pro rata complications” without a proportional contribution, Cornwell states. You should also consider that contributions are nondeductible, which can increase what you pay in taxes in the short-term.

Should You Use a Backdoor Roth IRA Contribution?

After considering the benefits and disadvantages of the backdoor Roth IRA approach, how do you decide if it’s the right choice? The decisions you make now, including whether to contribute to a Roth IRA, can have a material impact later on. For this reason, it’s crucial to consider how rolling funds into one will impact your taxes, both today and in the future, as well as the effect on your overall retirement plan.

“High-income individuals who have no money in an IRA and excess cash flow should consider this strategy,” says Marissa Beyer, CFP^®, Senior Wealth Advisor and Partner at Fidato Wealth. More specifically, she says that, in her experience, she starts by “creating a plan to ensure [her clients] are maximizing contributions to their respective retirement plans and receiving all matching contributions.” It’s only after that that she’d propose they “look to contribute maximum non-deductible IRA contributions so they can have a bucket of tax-free money build over several decades which is earmarked for retirement.” In this example, you can see that, for high earners, the backdoor IRA is sensible once one has already maxed out contributions to other plans, such as a 401(k).

It’s also important to consider the impact on your taxes in the present vs. the future. For example, if you’re a high earner today, but expect to be in a lower tax bracket later, it may make sense to deduct contributions. This is a topic to discuss in-depth with a financial advisor as you chart out your retirement plan.

Before committing to the process, we recommend you seek the counsel of an experienced professional, such as a financial advisor. If you need to find a high-quality expert, consider using this free matching tool. After filling out a brief questionnaire, it’ll pair you with an expert that aligns with your goals.

Frequently Asked Questions

Is a backdoor IRA legal?

Yes, the backdoor IRA is a lawful method to contribute funds to your Roth IRA as a high earner. In the past, it has been on the verge of elimination, such as in 2022 as part of the Inflation Reduction Act. However, it remains legal today.

What are the disadvantages of a backdoor IRA?

There are many tax considerations to make when using the backdoor IRA. For this reason, it’s easy to make mistakes and unknowingly increase the amount you’ll need to pay, such as with the pro-rata rule. Additionally, utilizing this approach may increase your short-term tax burden due to a high tax bracket and by making nondeductible contributions.

Do you pay taxes twice with a backdoor IRA contribution?

You do not pay taxes twice when you use the backdoor IRA method, provided you made nondeductible contributions to your traditional IRA to begin with. Per Cornwell, “Since it was a non-deductible contribution (i.e., taxes were already paid), there is no additional tax to convert it.” However, if you did make a deductible contribution, “you would be taxed on the converted amount since you never paid taxes going in,” he adds.