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What is a Backdoor Roth IRA?

What is a Backdoor Roth IRA?

Estimated reading time: 9 minutes

1998 was a notable year, marked by cultural milestones like the release of "The Big Lebowski", “Closing Time”, and the rise of Google. 

But for the financial world, the standout debut of that year was the Roth IRA. This innovative retirement account has since become a cornerstone of retirement planning, offering attractive tax benefits and financial flexibility.

The Roth IRA stands out for its unique tax structure. Contributions are made with after-tax dollars, leading to tax-free growth and withdrawals during retirement. This feature, combined with the absence of required minimum distributions (RMDs), makes the Roth IRA a highly sought-after tool for savvy investors.

Yet, there's a catch: not everyone qualifies to contribute to a Roth IRA. Income limits based on Modified Adjusted Gross Income (MAGI) and tax filing status can lock out high earners from direct contributions to these accounts.

That’s where the backdoor Roth IRA enters the fray. A backdoor Roth IRA is a strategy for those who exceed these income thresholds but still wish to benefit from the Roth IRA's advantages. 

In this blog post, we’ll delve into the intricacies of the backdoor Roth IRA, guiding you through the tax implications and some of the most pressing questions associated with this strategy.


Table of Contents


How Does a Backdoor Roth IRA Work?

Your ability to make direct contributions to a Roth IRA is limited by annual income limits set by the IRS. 

These limits vary based on your modified adjusted gross income (MAGI) and tax filing status. For context, MAGI encompasses your adjusted gross income along with various taxable deductions. These may include IRA deductions, student loan interest deductions, and rental losses, among others.

Taken together, these factors play a pivotal role in determining eligibility for direct contributions:

For Single Filers: For tax year 2023, if your MAGI is below $138,000, you're in the clear to contribute fully to a Roth IRA. However, as your income increases to between $138,000 and $153,000, your contribution capacity gradually phases out. If you’ve surpassed $153,000 in MAGI, direct Roth IRA contributions are off the table.

For Married Couples Filing Jointly: The full contribution limit is available if your joint MAGI is under $218,000. But, just like with single filers, this limit starts phasing out between $218,000 and $228,000. And, if your joint MAGI exceeds $228,000, direct contributions are not an option.

These income boundaries can be a significant hurdle for higher-income individuals and families who see the value in the Roth IRA's benefits. So, what's the solution for those who find themselves above these thresholds but still wish to leverage the Roth IRA's tax-free growth and withdrawals?

The backdoor Roth IRA.

This strategy provides an alternative for high-income earners barred from making direct Roth IRA contributions, allowing them to access tax-free retirement distributions.

How? It all starts with a contribution to a traditional IRA.

While traditional IRAs have their own income limits regarding tax-deductible contributions, there are no income limits on who can make nondeductible contributions. 


How to Set Up a Backdoor Roth IRA

Contributing to a backdoor Roth IRA is a two-step process. Here's how it works:


1. Make a Nondeductible Contribution to a Traditional IRA 

As long as you have earned income for the year, you can make a nondeductible (post-tax) contribution to a traditional IRA.

For 2023, the IRA contribution limit is $6,500, or $7,500 if you're 50 years or older.

Note: this is the total limit across all traditional and Roth IRA accounts. Make sure your contributions stay within these bounds to avoid any penalties.


2. Convert the Traditional IRA into a Roth IRA

After funding your traditional IRA, the next phase is to convert the traditional IRA to a Roth IRA. This step is where the "backdoor" part of the strategy comes into play. Because your traditional IRA contributions were nondeductible (post-tax), the conversion doesn't trigger additional taxes on the contributed amount.


Backdoor Roth IRA Tax Implications

While the backdoor Roth IRA strategy can provide valuable tax benefits, it's essential to be aware of certain tax implications and considerations during the conversion.


The Backdoor Roth IRA Pro-Rata Rule

If you have both pre-tax and after-tax funds in your traditional IRA, the IRS applies the pro-rata rule during conversions. This means that the taxable portion of the conversion is calculated based on the ratio of your pre-tax and after-tax IRA funds. 

For example, imagine you have $40,000 in a traditional IRA, of which $10,000 is nondeductible (after-tax) contributions and $30,000 is deductible (pre-tax) contributions and earnings. You decide to convert $10,000 from your traditional IRA to a Roth IRA.

Even though you're converting $10,000, only $7,500 of it is taxable because 25% of your IRA consists of after-tax money. The remaining $2,500 of the conversion is not taxed since it was a nondeductible contribution — it’s already been taxed.

The pro-rata rule ensures that you can't convert only the after-tax portion and avoid taxes. Instead, it spreads the tax liability proportionally across the entirety of your IRA funds.

Taxes on Gains: If your nondeductible contributions earned any investment gains prior to conversion, these gains are taxable upon conversion. To minimize the tax impact, consider converting soon after making your nondeductible contribution.


Backdoor Roth IRA Tax Reporting Requirements

To ensure compliance with IRS regulations, it's crucial to meet reporting requirements when executing a backdoor Roth IRA. 

Report the Nondeductible Traditional IRA Contribution: If your traditional IRA contribution is nondeductible, you must file IRS Form 8606 with your tax return for the year in which the contribution is made. This form reports the amount of your nondeductible contribution and helps establish that you've already paid taxes on this money. This is essential to avoid being taxed again when you convert these funds to a Roth IRA.

Report the Conversion to Roth IRA: Additionally, the conversion from a traditional IRA to a Roth IRA must be reported in your tax return for the year in which the conversion occurs. This is done using IRS Form 8606, Part II. You'll need to report the total amount converted.

If your traditional IRA contains both deductible (pre-tax) contributions and earnings as well as nondeductible (after-tax) contributions, only the portion of the conversion representing earnings and pre-tax contributions is taxable. Form 8606 helps calculate the taxable portion of the conversion based on the proportion of deductible and non-deductible contributions in your traditional IRA — this is the pro-rata rule in action.

Pay Taxes on the Conversion: If part of your traditional IRA includes pre-tax funds, taxes on that portion are due in the year of the conversion. The taxable amount is included in your gross income and taxed at your ordinary income tax rate.

No Penalty If Rules Are Followed: Although the conversion increases your taxable income, it does not trigger the 10% early withdrawal penalty, even if you are under age 59½. This is a specific advantage of the Roth conversion process.

It's crucial to keep accurate records of your nondeductible contributions and any conversions to a Roth IRA. These records are essential to ensure  you don't pay tax twice on the same funds and to accurately report any future distributions.


Backdoor Roth IRA Frequently Asked Questions

The backdoor Roth IRA strategy often raises several questions among investors. Let’s address some of the most frequently asked questions to help clarify this useful retirement planning tool:


1. Is a backdoor Roth IRA legal?

Although the IRS has never explicitly commented on the legality of the backdoor Roth IRA, this strategy appears to be compliant with current tax laws and regulations.

The IRS allows anyone with earned income to make a nondeductible contribution to a traditional IRA, and the IRS places no limits on the dollar amount that may be rolled over from a traditional IRA to a Roth IRA.

Seek out a trusted tax or financial advisor for help determining whether the backdoor Roth IRA strategy is right for you.


2. Do I need to have an existing traditional IRA to use the backdoor Roth IRA strategy?

No, you don't need an existing traditional IRA to use this strategy. You can open a new traditional IRA, make a nondeductible contribution, and then convert it to a Roth IRA. However, if you already have a traditional IRA with pre-tax funds, it's essential to consider the pro-rata rule during conversions.


3. Are there alternatives to the backdoor Roth IRA?

If your MAGI is above the Roth IRA income limits but you want an alternative to the backdoor Roth IRA, there are other options available. 

Investing in taxable accounts is one such alternative, offering the opportunity for investment diversification, albeit without the tax advantages of a Roth IRA. 

Additionally, Roth 401(k)s may be worth considering, especially for those with access to such a plan through their employer. These accounts provide similar Roth tax benefits with no income limits. However, most Roth 401(k)s restrict your investment options to stocks, bonds, and mutual funds.


Explore the Potential of Self-Directed Roth IRAs

As you weigh the benefits of a backdoor Roth IRA, it's worth considering the extended possibilities offered by a self-directed Roth IRA (Roth SDIRA). This type of IRA amplifies the inherent benefits of a Roth IRA by broadening the investment landscape far beyond what many financial institutions typically offer.

A Roth SDIRA isn't confined to the standard options of stocks, bonds, and mutual funds. Instead, it opens the door to a diverse world of alternative investments like real estate, private equity, precious metals, and even cryptocurrency. This level of diversification not only broadens your investment opportunities but also could serve as a hedge against market volatility.

One of the most compelling features of an SDIRA is its ability to align with your personal interests and areas of expertise. If you possess a deep understanding of real estate, for instance, you can leverage this knowledge by investing in rental properties or commercial real estate through your Roth SDIRA.

And of course, the core benefit of any Roth IRA, including a Roth SDIRA, is its tax-free growth. As long as you comply with the IRS rules, your earnings can grow tax-deferred, and qualified withdrawals in retirement are entirely tax-free.

To learn more about SDIRAs, download our SDIRA Basics Guide below.


Self-Directed IRAs: The Basics Guide Learn about your investment options, Self-Directed IRA rules, and much more! Download Now


Unlock the Potential of Roth IRAs with Entrust

As Roth IRAs mark their 25th anniversary, their relevance and utility in retirement planning continue to shine. 

The backdoor Roth IRA strategy may be a solution for high earners looking to leverage the tax advantages of Roth IRAs. This approach allows you to potentially bypass income limits and enjoy the benefits of tax-free growth and withdrawals in retirement. 

However, like any tax strategy, it's important to navigate the backdoor Roth IRA with a clear understanding of the rules and potential implications. Ensuring compliance with IRS regulations requires careful planning; enlist the guidance of a financial professional for advice tailored to your situation.

If you found this article helpful and are keen to explore more investing insights, we invite you to subscribe to our newsletter. Our updates will keep you informed on the latest trends, tips, and opportunities in retirement planning and investing.

For those who want to delve deeper, explore our Learning Center. From detailed guides to insightful webinars, it's designed to help you expand your knowledge and make informed decisions about your financial future.

Considering whether a Roth SDIRA is right for you? These investment accounts certainly aren’t for everyone

Talk to one of our SDIRA experts — they may be able to help you determine whether an SDIRA is right for you and your unique financial goals.

Note: Entrust does not endorse, recommend or advise on any investment product or service. Rather, Entrust provides the administration, information, and tools to make self-direction straightforward and compliant.

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